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Understanding Quality of Earnings and Preparing for a Successful Sale

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By: Kyle Orwick, CPA, CMAA and Amber Ferrie, CPA, ABV, CFF, CM, AA

Kyle Orwick, CPA, CMAA and Amber Ferrie, CPA, ABV, CFF, CM, AAThe time has come to sell your business. Do you know what the selling process looks like? The steps you must take to prepare?

While there are several steps in the transition process, every successful sale includes the following: conducting a quality of earnings report, identifying potential buyers, and becoming familiar with the selling process.

Conducting a Quality of Earnings Report
Quality of earnings due diligence is the analysis of your organization’s financial information by an independent party. This necessary step assesses and preserves the value of your business and prepares you for challenges that may arise throughout the sale.

A quality of earnings report highlights:

  • Normalized levels of EBITDA (earnings before interest, taxes, depreciation, and amortization) and the addbacks to bridge from reported to adjusted EBITDA
  • Fluctuations in annual and monthly financial balances
  • Revenue and gross margin by product, customer, or distribution segments
  • Operating expenses and employee analysis
  • Key balance sheet components
  • Levels of working capital needed to operate the business

It also investigates and answers questions like:

  • Have you had any significant one-time events, infused significant growth, or added process improvement capital that affected your financial performance?
  • Have you prudently managed your working capital and cash flow?
  • How do your compensation packages compare to the market?
  • Have you reasonably forecasted your growth?
  • What are the capabilities of the management team which will be in place after closing?
  • Have you outgrown your current technologies?

These areas are intended to provide assurance to potential buyers that there are no “skeletons” hidden in the numbers.

Identifying Your Potential Buyers
Quality of earnings due diligence is one of the first steps in preparing for a sale. Once you understand your business from a buyer’s perspective, it is time to consider the universe of potential buyers.

The market generally splits buyers into two categories: strategic and financial.

Strategic buyers typically buy 100 percent of your business and assume all responsibility for it. Examples include family members, employees (such as through an ESOP), or even outside parties like competitors or customers.

Financial buyers are organizations such as private equity groups (PEGs), venture capital firms, or hedge funds. Financial buyers often approach opportunities with a “partnership” mindset and have more flexibility to acquire majority or minority interests. But keep in mind that oftentimes, these organizations require majority ownership, so you will want to ensure you share the same goals and values with financial buyers prior to selling.

The most appropriate buyer typically depends on a multitude of factors – the most important being your underlying reasons for selling and the desired outcome you hope to achieve.

Familiarizing Yourself with the Selling Process

While every sale is different, and every situation requires careful consideration, planning, negotiating, and analysis, you can generally expect the following actions to take place:

Step 1: The potential buyer signs a nondisclosure agreement. 

This gives you, the seller, peace of mind as you provide them, the buyer, with enough information to help them determine a price. Do not give them any information until they have signed a nondisclosure agreement. This will protect your business and ensure the buyer only uses the information to formulate an offer.

Step 2: The buyer delivers an Indication of Interest.

After conducting preliminary due diligence, as well as any additional research, the buyer will deliver an Indication of Interest. This outlines the general terms and conditions for the intended transaction and includes a value range of your business. If the buyer’s findings agree with your own business valuation, you can give them more access to key contracts or agreements, customer lists, or more detailed financial information.

Step 3: The buyer delivers a Letter of Intent.

Once the buyer has a cohesive picture of your business, they will home in on a more precise value. They will lay this out in a Letter of Intent, which covers the purchase price, the structure of the deal, whether it is an asset or stock sale, the escrow parameters, the working capital allowance and other details. While this is a very intentional document, it is non-binding.

Step 4: The seller and the buyer draft and sign a purchase agreement.

After negotiation, review of legal terms, and final due diligence, a purchase agreement is created. An experienced lawyer or business advisor should play a key role in drafting the legal documents used to complete the sale. The purchase agreement is a binding document for both parties and will be a road map for how any issues will be resolved after the deal is closed.

Don’t go through this transition alone

Selling your business requires emotional and psychological strength. Without proper preparation, you can experience deal fatigue, analysis paralysis, and you may end up selling your business for less than what it’s worth. For a successful and stress-free transition, it’s critical to get advice from trusted business advisors who have experience successfully advising clients on sales and transitions. They can help you understand your transition options and map out an effective exit strategy that ensures you accomplish your goals.

Speak with our team of experienced advisors to learn more.

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