A quick note:

Make sure to check out my business SMB Business Plans if you're in need of a business plan for your SMB acquisition. We know how to write these business plans in the exact style that SBA lenders are looking for.

Also, check out Pioneer Tribe Insurance if you need insurance around your business acquisition.

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This newsletter was written with my good friend Chris Barrett - a skilled CPA who has worked with me on several deals. He's the best in the business, and I highly encourage you to follow him on X and reach out if he can help you. Here's his firm's website as well.

Almost everything in today's newsletter comes from Chris' experience and observation having worked on countless business acquisitions.

Today, Chris and I are going to talk about Quality of Earnings (QoE) and why it's important to get a QoE analysis done when buying a business.

Most business buyers have heard the term Quality of Earnings, but most don't know the details of what it entails.

The reason a buyer has a QoE done is to help the buyer determine if the amount they are paying for the business is reasonable.

Don't be caught holding the bag!

Here's a real life example of how a QoE helped one of Chris' clients:

Here are the critical components of a business acquisition that a QoE will analyze:

We'll start with EBITDA, which is probably the most talked-about metric in the land of business buying.

The problem with EBITDA is that everyone calculates it differently. There is a rigid GAAP (Generally Accepted Accounting Principles) definition of EBITDA, but that's not what most SMB sellers are using when calculating their EBITDA.

Instead, the buyer and seller in an SMB transaction are trying to get to what I call an "Economic EBITDA".

GAAP EBITDA does not equal economic EBITDA (this is a common misconception).
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The goal of Economic EBITDA is to get a true sense of the economics of a business.

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Adjusting EBITDA

The first step here is to reconcile the reported EBITDA to a reliable source of information.

In larger deals this is typically audited financial statements, while in smaller deals it is often the tax returns (as audited financials don’t usually exist).

The second step is to analyze the seller’s proposed adjustments to EBITDA for reasonableness.

Example:

The final step is to identify further adjustments that could effect company value.

These adjustments can be broken down into 3 major categories.

1. Non-recurring transactions
2. Corrections of errors/timing
3. Pro-forma

Example:

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Net Debt

Net debt is the calculation of items that are “debt-like” while not actually meeting the standard definition of debt.

These debt-like items will lead to non-operating cash outflows that will be the buyer’s responsibility post-closing.

There are a variety of items that could fall into this category and I’ve listed a few below as examples.

• Transaction related costs like deal bonuses for employees
• Deferred capex
• Prepayment penalties
• Deferred revenue
• Litigation claims

Net working capital

If a buyer closes on a business with a less than normal level of working capital, additional cash may be required in order to finance operations.

A QoE will help a buyer do 3 things.

1. Establish a working capital “peg” for use in the purchase agreement
2. Understand the temporary financing needs of the business.
3. Understand when the revolving line of credit may need to be drawn on.

This is done by analyzing:

• Historic working capital swings and seasonality
• Identifying periods of time where working capital demands are higher
• Remove non-working capital items from current assets and liabilities
• Make adjustments where needed when adjustments are made to EBITDA
• Calculate and analyze the cash conversion cycle

Example

One final note on NWC…

If your seller and their counsel does not understand working capital (like is common in smaller deals)… you’ll save yourself many headaches by including no WC in the deal, adjusting purchase price accordingly and borrowing what you need.

Thanks to Chris for his help on this piece! Make sure to follow him on X.

How We Support Business Buyers

Beyond financing expertise at Pioneer Capital Advisory, my other companies offer essential services for business buyers.

SMB Business Plans: Expert Business Plan Development

A comprehensive, SBA-compliant business plan is crucial for securing financing. SMB Business Plans, led by Joe Thomas, specializes in crafting acquisition business plans that meet SBA standards.

For assistance, contact Joe at joe@smbbusinessplans.com or visit https://www.smbbusinessplans.com/.

Pioneer Tribe Insurance Solutions: Customized Insurance for Acquisitions

Insurance is vital for protecting your investment. Pioneer Tribe Insurance Solutions, managed by Jelani Fenton, offers tailored insurance solutions for business buyers. Visit https://www.pioneertribeinsurance.com/ or reach out to Jelani at jelani@pioneertribeinsurance.com

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Disclaimer: The information in this newsletter is for informational purposes only and should not be considered legal or financial advice. Business buyers are encouraged to consult with their legal counsel and accountant to ensure the proper structuring of their transactions and to fully understand the tax implications of seller financing.

Thanks for reading! Feel free to reply directly to this email with any questions or thoughts.