Quality of Earning vs Business Valuation: What is the Better Tool for M&A Success?

I was with Tom Bayer, CPA, CExP and Mike Rudolph of Sikich a couple of weeks ago talking about the quality of earnings reports making their way into M&A deals that were typically too small for that type of accounting undertaking. It then got me thinking about which was more important in the M&A world I serve: Quality of Earnings or Business Valuation (for sale purposes)?

The majority of deals die in one of two ways:

1. Value Gap between the buyer and seller
2. They are unable to survive due diligence

The idea that a Quality of Earnings (QoE) report is a more useful tool than a business valuation during the sale process stems from the fundamental difference in what each tool provides and how they contribute to decision-making in an M&A process:

Market Feedback Defines Value

• Market-Driven Valuation: In the M&A process, the market itself often determines the value of the business. Buyers bring their perspectives, motivations, and synergies to the table, which can drive the price above (or below) what a standalone valuation report suggests. This feedback loop renders a traditional valuation less predictive and more of a starting point.
• Dynamic Pricing: The M&A process incorporates variables like strategic fit, competitive interest, and buyer synergies that aren’t fully captured in a static valuation model. QoE reports ensure the financial story aligns with what buyers are willing to pay.

QoE Validates and Builds Confidence

• Transparency and Trust: A QoE report provides a transparent breakdown of the company's earnings, offering buyers confidence in the reliability of the numbers. This detailed understanding is crucial when multiple buyers are assessing the same business.
• Risk Mitigation: QoE identifies potential risks, such as non-recurring revenues or expense anomalies, that could undermine the valuation or derail a deal entirely. Sellers who proactively address these issues can maintain buyer confidence and avoid a deal retrade prior to closing.

Selling to Sophisticated Buyers

• Valuation Isn’t Final: Sophisticated buyers (e.g., private equity firms) may disregard seller-provided valuations entirely, instead conducting their own analyses. QoE reports, on the other hand, are often seen as neutral and objective, making them more trusted tools.
• Focus on Earnings Quality: Many buyers are less concerned with a valuation number and more focused on earnings' sustainability and growth potential, as identified in QoE reports.

Practical Considerations

• Time-Sensitive Utility: QoE is actionable during the sale process, helping adjust expectations, strengthen negotiations, and address buyer questions in real-time. Valuation is static and often completed before entering the market.
• Bridging Expectations: By validating financial performance, QoE reports can bridge the gap between seller expectations and buyer perceptions, fostering smoother negotiations.

Conclusion

While business valuation is an essential starting point, the QoE report often takes center stage during the sale process. By verifying the financial narrative and addressing buyer concerns, QoE enhances trust and clarifies for buyers to confidently submit offers and sellers know they will withstand financial due diligence scrutiny. Ultimately, the market determines the final price, and a robust QoE ensures that valuation assumptions align with market realities.

????♂? I guess I still need them both