Aug. 11, 2020

Ep 7: Demystifying Due Diligence: The Q of E

Ep 7: Demystifying Due Diligence: The Q of E

Due Diligence is a key part of any transaction when buying or selling a business - but also one that can be confusing, or even daunting for middle market business owners. In this episode, Cheryl Aschenbrener, Co-Leader and Partner of Sikich Transaction Advisory Services, joins us to discuss the important role of the Quality of Earnings, or Q of E, in the due diligence process, and how it is impacted by the COVID environment.

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For more information on Cheryl Aschenbrener or Sikich Transaction Advisory Services, go to https://www.sikich.com/partner/cheryl-aschenbrener/.

Looking for more episodes or playlists? Find them on our Right In the Middle Market website, https://www.rightinthemiddlemarket.com. For more information about us, or to inquire whether we could help you and your business, go to the website SLS Capital Advisors and The Gaffin Group, https://slscapitaladvisors.com.


Transcript

{"version":"1.0.0","segments":[{"speaker":"Stephanie Gaffin ","startTime":0.0,"body":"Quality of earnings, due diligence, they're all of these kinds of phrases that, when you hear about them in the buying process, they are sometimes confusing, we don't always know what they mean. So today, we are going to try to dive in and understand a little bit more about some of the technical aspects and due diligence.\n\nWelcome to Right in the Middle Market, a podcast about pragmatic perspectives on running, growing and selling your business. We talk about the challenges, decisions, and most importantly, the actions business owners can take to create long term value in their companies. \n\nWelcome to Right in the Middle Market today. I am so excited to have a guest here with us. We have Cheryl Aschenbrener, who is the CO leader and partner of Sikich Advisory Services. Cheryl, welcome.\n"},{"speaker":"Cheryl ","startTime":58.0,"body":"Thank you! I'm so happy to be here with you today.\n"},{"speaker":"Stephanie Gaffin ","startTime":60.0,"body":" We're excited to have you. So, one of the things that I wanted to start with, I know that one of the services that you guys provide is during the closing process or during the due diligence process, when somebody is getting ready to go through an M\u0026A process, and you do a lot of the quality of earnings as part of the due diligence. So first of all, people hear about a Q of E or quality of earnings. What is it?\n"},{"speaker":"Cheryl ","startTime":90.0,"body":"Simply put, a quality of earnings is really a deep dive into understanding the business, and a report to lessen those surprises or skeletons in the company's numbers. Values are multiples for which a sale is based on are often constructed on a multiple of EBITDA, or now more commonly referred to as EBITDAC which is earnings before interest, taxes, depreciation amortization. Now adding in COVID. And how it affects as well on the earnings. So a Q of E really focuses on the adjustments of that company's reported EBITDA and its sustainability or the quality of the company's earnings.\n"},{"speaker":"Stephanie Gaffin ","startTime":135.0,"body":"Okay, so basically, as we're getting into due diligence a Q of E is designed, let me make sure I understand this, a Q of E is really designed to help understand if we're basing the entire valuation and the sales price off of that EBITDA, is it really what we believe it is, what both sides believe it is?\n"},{"speaker":"Cheryl ","startTime":155.0,"body":"Correct. It's really looking at, are there add backs? Are there deducts that need to be taken? A lot of companies will look at their company as a little bit of a paycheck. So they may think about putting a new deck onto their home, and they take a distribution out of their company for that deck, which is fine when it is a family owned business or a company that own a substantial portion of. However, the best way to explain to clients or a customer that that may not be the best decision a few years before selling your company. Because to explain that to the buyer that's coming to the table, that could be a half million dollar mistake.\n"},{"speaker":"Stephanie Gaffin ","startTime":199.0,"body":"Right. Well, it sounds like maybe there are some surprises that you find as you're doing a quality of earnings that then the seller or the business owner looks back and maybe things that they wish they had known beforehand?\n"},{"speaker":"Cheryl ","startTime":214.0,"body":"Absolutely. I would say probably there's two great things I always like to say to a business owner, I wish they would have known beforehand. One is the true value of their company. So a recommendation that we always give to clients is to do a valuation, at least every two to three years that can sound overwhelming, but a lot of times a big break in potential sale can really come from, what the true value of their company is versus what they believe is the value of their company. So coming to the table with two different numbers can be quite distributionly obvious, and can really change a person's mentality. I would say the other thing that's always key is bringing the whole family to the table when there's a potential sale or buy of a company or even just a portion of it. Because if it is a family owned business, it affects the entire family so that that husband or wife or significant other may be sitting at home or in another position outside of the home. It can be quite a surprise when someone doesn't have an office to go to every day or something to run. Or if there's children in the business. Sometimes they have the assumption that maybe that company was going to be theirs someday and maybe isn't going forward. So those are two really key aspects, I think prior to thinking of even going to a quality of earnings sort of stage or looking to sell your company or buy.\n"},{"speaker":"Stephanie Gaffin ","startTime":302.0,"body":"Well, and I think Cheryl, what you're talking about is a great example of where the quality of earnings is not just an abstract accounting tool, it really is an integral part of the process. And it sounds like you guys really have a chance to become part of the team part of the M\u0026A team.\n"},{"speaker":"Cheryl ","startTime":318.0,"body":"That is so spot on. We don't like to say a quality of earnings is a is a selling tool, but it truly is, because a lot of people think I have an audit or I have a review done of my company every year. What are you saying? But an auditor review is really it's a test service. So it's in gap format. So it's just telling you what the professional standards need to say. Quality of earnings is again, looking at that quality of those earnings, what things are in there that are not a testament to that true company's value?\n"},{"speaker":"Stephanie Gaffin ","startTime":352.0,"body":"So all right, you've convinced me a Q of E is a good thing to do, right? But aren't Q of E's is only for big deals? It seems like you know, this is something that's a nice tool to do but what relevance is there really in the middle market?\n"},{"speaker":"Cheryl ","startTime":367.0,"body":"Even pre-pandemic, right? Obviously, life has changed a little bit for the majority of companies out there. Even before, these are not large company type reports. When you make the decision that you want to sell or buy a company, you want to do it fast, right? So, there's always hiccups in the road, there's always a skeleton in the closet as much as you don't think, we can really help to make we always like to say we can make you more money with that quality of earnings. You know, there's, there's statistics you can pull for every dollar you spend, you know, you can probably gain at least $10 to $20 more by performing that quality of earnings because you pull so much off the table as far as time spent with other parties that will be involved and mixed into the magnitude be it attorneys, accountants, insurance agents. Time is Money, we all know that right time is money. So the shorter we can make that window is really relevant. And, you know, people say, what is the quality of earnings report? You know, there's so many different avenues to that and you can scale those to any budget. So, you know, once you know what those add backs or deducts are or what you think are the the multiples that you're thinking you're coming in with, you can pull those out pretty quickly and budget to any sort of tactic that you're looking for.\n"},{"speaker":"Stephanie Gaffin ","startTime":446.0,"body":"Is there a minimum deal size below which it just is really hard to make the numbers work?\n"},{"speaker":"Cheryl ","startTime":451.0,"body":"Honestly, no, I would say a lot of times, even just different industries. You know, if you look at like a construction type company, sometimes the smaller deals actually wind up taking more time, because the quality of those financial statements probably isn't of the magnitude of the larger corporations. So you can find yourself or they're using ERP systems such as Excel, or you know, QuickBooks, so a little bit less of an astute ERP system so when I said construction contractors, percentage of completion, you know there's a lot of things there that you know we can pull and look at margins and pricing and how they're valuing their actual bottom line earnings.\n"},{"speaker":"Stephanie Gaffin ","startTime":496.0,"body":"So this is one big area that I know you guys work in around due diligence is around the quality of earnings. Don't I remember that Sikich also does work around technology due diligence. \n"},{"speaker":"Cheryl ","startTime":507.0,"body":"Correct.\n"},{"speaker":"Stephanie Gaffin ","startTime":508.0,"body":"What is technology due diligence?\n"},{"speaker":"Cheryl ","startTime":511.0,"body":"So it's interesting you ask that, because there are so many aspects to technology due diligence, right? You know, we usually do like a series of site visits, we'll do interviews, we'll do tests, and basically we're assessing that IT environment. So during that we'll look, are there existing capabilities? Are there risks out there? Are there areas of concern? But then also, you know, there's areas that could be an opportunity that maybe could be leveraged. You know, we Look for those potential hidden costs, maybe gaps, or anything that might materially impact that target company with the overall health of that IT function. And then there's also, you know, the personnel that they have. So looking at their workforce, and what strengths or weaknesses they may have, or again, those leveraging capabilities by putting two companies together.\n"},{"speaker":"Stephanie Gaffin ","startTime":563.0,"body":"So it sounds like when you're doing that you may find some gaps in technology. So are the things that you find do they always negatively impact a deal? Or might there be a positive impact to a deal as well?\n"},{"speaker":"Cheryl ","startTime":576.0,"body":"Absolutely. Honestly, we probably find more positives than negatives, usually. I would say the only negatives that usually come out I shouldn't say only but some of the negatives that may come out are breaches that weren't there when the transaction was happening. So there's a huge positive spin to that without that IT diligence from that prospective seller, they wouldn't have the opportunity to come back and say that breach was there, and our IT due diligence personnel can actually have that picture of what that system looked like and prove that that breach was there. So not taking away from the working capital of that new buyer. So huge positive.\n"},{"speaker":"Stephanie Gaffin ","startTime":620.0,"body":"Yeah, that would be really important. And I think it's, I guess, Cheryl, when I think about it, that one of the things that we always strive for is to say, look, it's really much better if there's no surprises on either side, if there's really good transparency, and because that's what allows there to be a good deal. And quite frankly, and especially in the middle market, a lot of times there's a relationship that will continue for a period of time after close, and we always tell our clients, it doesn't do you any good to try to hide things. You know, yes, we want to always put our best foot forward, but to try to hide things just not only is it obviously dishonest, but it actually doesn't serve you well in the end.\n"},{"speaker":"Cheryl ","startTime":662.0,"body":"I couldn't agree more. Full transparency is probably the easiest way to win that deal and keep that deal positive. Because ultimately, what are we looking at? It's working capital, right? So again EBITDAC is going to be quite different, you know, because there's so many different things that are going to come into diligence going forward. That you know, we're really gonna have to take a hard look at and be honest about.\n"},{"speaker":"Stephanie Gaffin ","startTime":688.0,"body":"So I want to come back to that concept, but let's take just a moment for a word from our sponsor. \n\nRight in the Middle Market is brought to you by SLS Capital Advisors. SLS Capital Advisors is a boutique financial advisory firm working directly with middle market leadership, to tackle critical growth opportunities, including exits, mergers and acquisitions and access to capital. The principles of SLS Capital Advisors bring deep industry financial and consulting experience to firms seeking tailored strategic opportunities, including capital for major growth initiatives and alternatives for those evaluating corporate transitions and exits. SLS Capital Advisor services include managing effective exits and sales processes involving sophisticated buyers such as strategic purchasers, financial buyers and operator to operator transactions and raising capital to fund our clients growth including debt and equity elements. They also assist companies and capturing growth opportunities through focused and effective organic growth and M\u0026A programs and unlocking profit potential through business portfolio rationalization and divestiture. SLS Capital Advisors focused on delivering consultative executions for clients seeking strategic growth and capital. Find us at SLSCapitalAdvisors.com to learn more about how we can help you. \n\nWelcome back. We are so pleased to have today, conversation with Cheryl Aschenbrener from Sikich Advisory Services, and talking a little bit about some of the surprises that you find in due diligence and you were talking a little bit about EBITDAC. Tell me more about EBITDAC. You mentioned that at the beginning, but practically speaking, so EBITDAC , where folks are trying to factor in the impact of COVID, to how they're thinking about the valuation of a company. How are you seeing this actually take place in practical terms? We always try to be really pragmatic here, right in the middle market. So in pragmatic terms, what does this look like?\n"},{"speaker":"Cheryl ","startTime":812.0,"body":"I think we're going to see a lot more Q of E's being performed. I think in almost every transaction, there's just on a go forward basis, there's so many changes due to the pandemic. Just thinking off the top of my head, there's the cares act financing programs, you know, how are those affecting companies that are out there? The supply chain disruption, be it internally or externally. Concentration of vendors, customers, just the employee welfare and how that's affecting their personnel and their employees. Expenses that have been delayed, or maybe increased, you know, with cleaning and things of that nature. Are there things that have happened there? Just delayed capital expenditures, delayed repairs and maintenance, cash conversion cycles are going to be huge. Just looking at what are the opportunities or maybe possible repercussions that may arise post acquisition. So true working capital structure is going to be the the new new regime. And I think there's going to be a lot of importance and scrutiny placed on what is what is temporary, and what's actually now permanent in nature.\n"},{"speaker":"Stephanie Gaffin ","startTime":892.0,"body":"It's interesting that you say that. In one of our earlier episodes, we talked a little bit about being in the middle of a pandemic is this a good time to sell your business, a terrible time to sell your business, or somewhere in between. One of the things that we put forward, was the idea that if you understand the impact to the degree that you can understand the impact of Coronavirus, that you can factor that into deal structure. Would you agree with that? Or if not, what, what else would you put forth?\n"},{"speaker":"Cheryl ","startTime":923.0,"body":"I think we're going to see a lot of change in deal structure. We're already starting to see some of them coming through. That being a little less cash being placed out there. A lot longer earnout agreements. And I don't want you to think that those are negative. I think, actually, as a seller, I would be more excited about a longer earnout agreement because again, we don't know what's considered temporary versus permanent. And you may see a lot more equity being left in the company for yourself, which could be a positive or negative depending which side of the fence you're on.\n"},{"speaker":"Stephanie Gaffin ","startTime":960.0,"body":"So let's come back to talking about due diligence in general. And I'm curious, I'm sure you've got some great stories. But what are some of the surprises that are found? Because I don't know about you. But I always think that when I'm going through due diligence when we're helping a client through a due diligence process, finding surprises is generally not a good thing. What are some of the surprises that you guys have have found as you've gone through a due diligence process?\n"},{"speaker":"Cheryl ","startTime":987.0,"body":"The first one is is not really a surprise from a due diligence project. I think it's just the surprise that no one truly knows what due diligence is. And I don't think they're quite ready for it. It's very intense, but you also have to remember this is probably one of the most monumentous occasions in your life, in your history. I mean, the company that you have is probably your nest egg, your baby. And if you think about it, it's without due diligence, it could be one of the most costly mistakes you make, or could be one of the most financially rewarding. So there's that aspect, but I would say, let's see, as far as a big surprise, a lot of times it actually comes in the personnel. And those are things people don't think about. We do a lot in the regime of the manufacturing space, just based in doing a lot of due diligence on Midwest companies. And just finding out that the personnel may not truly be US citizens. So probably one of the biggest surprises that I have had in one of my Q of E's was finding out the next day after the sale, there were no employees, or that purchaser to come back to having because they were not US citizens. So things you don't think about usually become some of the biggest surprises, right? Because everybody thinks, okay, they're going to be looking at my revenue streams. They're going to be looking at my receivables, my collections, my vendors, any concentrations, all the simple stuff. It's the the one offs that no one is prepared for. State and local tax is also another huge one. A lot of times people really don't value the tax aspect of it because they're saying this is an asset sale, which is a lot of what is done currently, versus stock sales. And those leave trailers and can cost quite a bit.\n"},{"speaker":"Stephanie Gaffin ","startTime":1103.0,"body":"So I want to go back to something you said a few minutes ago, which is that one of the challenges for people going through this for the first time, which again, let's face it, most middle market business owners will go through this once in their lifetime, maybe a couple of times, but this is not something they do frequently. Which is part of where we try to demystify this process a little bit. So, can you give us just a quick overview of what is that due diligence process? What should business owners expect as they go through a diligence process?\n"},{"speaker":"Cheryl ","startTime":1135.0,"body":"Correct. Yeah, no good question. I would just say, the main thing we always look at is the trailing 12 months. And so we really scrutinize your income statement, I mean, we'll get to the balance sheet, but the biggest scrutiny becomes on the revenue streams and the expenses associated with them. So there's, I would say, a good day worth of interviews with key personnel. So being prepared for that. And then depending on the structure of your company, you know, say you're a project based company, you know, just pulling through projects individually. And looking at the revenue streams, looking at the contracts, it's really making sure that everything has been recorded appropriately. Because most deals cash is not left in the company, the cash is taken away. So again, it comes down to what that process revolves around is that working capital, so what we're really focused on is the timing of the revenue, the receivables and the cash and how that turnaround happens. So building that working capital stream going forward.\n"},{"speaker":"Stephanie Gaffin ","startTime":1199.0,"body":"So you guys are typically used then during it sounds like kind of the later M\u0026A part of the process. Are there places where your services are actually underutilized? \n"},{"speaker":"Cheryl ","startTime":1211.0,"body":"Absolutely. I think as you can kind of hear today, we're not always about just putting out that Q of E report. It's really getting educated. I think that's the one thing that a lot of business owners really need to educate themselves as to what type of transaction they're looking for. There's so many opportunities out there, you know, is it a strategic buyer? Is it a private equity? Is it a venture capitalists? Do they want to work with a broker and investment banker? Are they a good ESOP candidate? Are they a good management buyout candidate? What is an asset sale versus a stock sale? So, underutilized is just sitting down and educating yourself with someone such as myself, who has you know, the rapport to know what all those different terms are and how that facts that individual personally, because all of them have different tax ramifications.\n"},{"speaker":"Stephanie Gaffin ","startTime":1266.0,"body":"And I know certainly, you know, from our perspective, Cheryl that we always try to think of and we always try to think about how do you pull together for a client who's going through this process, a team who is really there for the client, they're really there to help that seller, make sure that the transaction is as easy as it can be, but that really gets to the objective that they're looking for. And so, I know that, you know, one of the things that I noticed Sikich does really well, is to be a collaborative part of that team and really there to support the seller and the buyer, to make sure that the transaction comes out the way that they're hoping for.\n"},{"speaker":"Cheryl ","startTime":1301.0,"body":"Thank you so much for saying that. And it can't be said enough. We understand that a lot of times we're coming in as a new partner to these clients. We're not looking to replace their accountant or their tax advisor. You just have to understand that there are people that do this day in and day out and can, they're really there to help. It's really looking for that perfect bedside manner partner, that's going to be with you. Because we do a Q of E process, any sort of due diligence. We're very involved, you get to know us very well, we get to know you very well, intricately. So, again, not replacing anyone, we're just looking for that special transaction to assist them.\n"},{"speaker":"Stephanie Gaffin ","startTime":1346.0,"body":"So you know that here at Right in the Middle Market, we are all about pragmatic advice and insights. So in closing, I'm going to ask you, and you've given so many great tips today, but in closing, if there is a business owner out there today, who's listening who's thinking about selling their business, maybe in the near term, maybe a little further out, or maybe they're already starting that process, what are two actionable things that you would suggest that they could do?\n"},{"speaker":"Cheryl ","startTime":1374.0,"body":"Know that the due diligence process of the past has really changed going forward. Business owners, I really need to consider technology quite a bit more, and how to work that remotely. I think the whole due diligence process that we had been used to in the past has changed. We're going to be doing a lot more remotely versus on site, which is going to be quite different for both parties. Because obviously, the person coming in are buying and selling wants to really know the culture of those people that they're working with as well as selling to. So I think that's going to be interesting. And then one of the biggest ones with COVID happening, I really want to educate the business owners to understand that letter of intent. It's a key piece when you're approaching a sale. And I really want them to have a clear explanation of what is and isn't included in the calculation of working capital. And be sure to note whether it's pre or post COVID I think is going to be very key going forward.\n"},{"speaker":"Stephanie Gaffin ","startTime":1435.0,"body":"Wonderful. Cheryl, thank you so much. It has been such a pleasure to have you here today. I'm Stephanie Chambliss Gaffin and you've been listening to Right in the Middle Market, a podcast about running, growing and selling your middle market business. We'd love to hear your comments about today's episode or ideas for topics you'd like most to hear in the future. Send me a message on LinkedIn or drop me an email at podcast@gaffingroup.com. Until then, be well and be courageous.\n\n"}]}