Quality of Earnings Unpacked: What ETA Buyers Need to Know Before LOI

It's always fun when you follow the fun AI guys and you get an accounting lecture, so sorry ahead of time. My name's Mike Jerman. I was a grumpy old Air Force captain turned PwC director, first in audit and then in the deal transaction space, before leaving to start Hollywell in 2018. The joke goes that we started Hollywell because my wife wouldn't move to Houston from London with PwC. The real honest answer, just like you guys in this room, I had an itch to try something. I commend all the searchers in here for finding that itch and doing something that I found otherwise very terrifying. Good for you guys for going after that.

Fast forward, started Hollywell. I was the janitor, head of ops, IT, HR, everything you are as a founder-owner-operator. Something worked. When we say QoE, we're talking financial due diligence. Adam and I were doing large private equity work, upwards of $500 million EBITDA-sized public-to-private or large SPOs. So we have very strong international deal practice experience within Hollywell. Alongside that, although fractional CFO has become a bit of a marketing term, we are a true interim and project-based CFO practice, from large private equity portcos and funds down through search and ETA. It's a true accounting leadership shop. We do not have juniors per se.

Along that journey, we have sold to private equity a couple of times, so we are part of the enemy now. Jokes aside to anyone from PE, Adam and I grew up in PE. We were going to do a corny game show, but no one wants to hear accountants try to be entertaining. So we're going to let you ask questions about our journey from founding to smaller PE ownership to growing again, buying eight or nine practices, selling to big PE, and now being on steroids with our growth. That journey is a very different story than what you guys are trying to do. Ask any and all the questions you'd like. We'll be as transparent as we can.

Adam Webster: Nice to meet everyone. My career started at Lockheed Martin. I went and did an MBA, then I was at PricewaterhouseCoopers for 15 years. First two years I was doing auditing, then moved over to the financial diligence practice in 2012. I moved over to Hollywell to join Mike and the team in 2024 and have been enjoying it ever since. The intent of Hollywell, as Mike described, is bringing that big accounting firm experience down to the lower middle market and lower end of the market.

Mike: You're going to hear it a lot as you guys go on your own journeys about having to fire yourself, which to me was quite terrifying. We tried to find Adam for four or five years, and when he finally made the jump and took over the diligence practice, I cannot tell you how much we should have found Adam sooner. If you get anything out of this session outside of a bunch of nerdy accounting theory, please find that person and fire yourself so you can replace them and go on to the next step.

What is a QoE? It is not a CPA-regulated procedure. But any good quality of earnings, any good financial due diligence, should do audit-like procedures. The same things we used to do when we started large company audits, we start our QoE with. Whether you use Hollywell or another provider, there are good ones out there. There are also some absolute garbage firms that just put a bunch of pretty numbers on a PDF and hand it back to you. Get a real scope of work. Get real audit-like procedures done. A QoE is not a regulated CPA, AICPA-governed procedure. It is a set of procedures governed by the firm that does them, but hopefully there's some substance to them.

Adam: The first day of training at PwC's diligence team, someone got on stage and said, "Does anyone know what financial diligence is?" The best explanation I've heard over the years is, you wouldn't buy a house without getting a home inspection, and we are the financial home inspector. We're going to help understand what the financial situation is of the business you're buying.

When to call: We're happy to be a resource pre-LOI. There are a lot of SIMs you're going to read, a lot of adjustments you're going to go through, even just to get to that LOI phase. If you pick up a book and you don't understand an adjustment or don't feel great about it, give us a call. We're typically engaged either immediately after you sign an LOI or within a couple of weeks. Every small deal process is going to be different. The level of access you get to the seller's financials is going to be different on every deal. We have clients who get really good access and really good data pre-LOI, so we get a call the same day they get under LOI and we're off and running. There are also processes where you may have very limited information pre-LOI. In those situations, we often recommend, once you get to LOI and get that next level of access, spend that week or 10 days to go through your higher-level questions and do that higher-level financial review before you start spending money on advisors.

Mike: A lot of you are either starting your search or in it. If you want to just talk shop, whether it's IBISWorld reports on certain research, or comps from PitchBook on where multiples are standing or multiple creep, ping us. We'll send it to you sight unseen. We love this stuff. We do a couple hundred QoEs a year from companies that are $30 million in EBITDA down through ETA and traditional search. We are a full-service accounting shop.

Adam: For business owners thinking about the eventual exit process, the answer is always now. If you're thinking about selling, the sooner you start preparing, the better. There's quality of earnings on the sell side as well.

Overview of the process: it's typically a three- to four-week process. When we kick off, we align on scope. Every deal is a little different. You want to make sure the scope your advisors are accomplishing is aligned with the industry, the size of the business, and the overall risks. Once we're kicked off, we'll get you an information request list and have a kickoff call with the seller. It's important that the seller doesn't feel overwhelmed. Having a call to walk through the list and understand what data they have and what they don't have is important. You don't want them to run off and think they have to create a bunch of new information for two months. It's a stressful process and one the seller has probably never been through.

The end goal is agenda and meeting materials that have all the analysis, which you'll put back in front of the seller. We'll have a diligence call and debrief with you on any red flags. Our goal is an unbiased view, positive or negative. If you thought EBITDA was a million going in but we found X, Y, or Z issue, maybe it's more like 800 or maybe it's 1.2. We'll have that discussion so you can make real-time decisions on whether to pause or stop.

Mike: You guys are going to look at a lot of SIMs, a lot of decks, a lot of presented EBITDA from sellers and potential iBanks and brokers. How often do you think we find out that EBITDA is higher than what's in the SIM? I think I've seen two in my career. It does happen, but sellers are motivated to present the business in the most aggressive way possible. Our view is to give a balanced opinion on the earnings.

Adam: The biggest driver of positive surprises is typically longer-term project-based businesses where small businesses don't account for long-term projects properly. It's complicated. When you dig in, there's often timing differences that could shift earnings left or right.

That first phase is two and a half weeks of the four-week process. We cover all the key analyses, then there's a check-in between phase one and phase two. We typically look at three periods: right now that's fiscal '24, fiscal '25, and an LTM period through 2026, whatever the most recent closed month is. We go through all the trial balances and general ledger data on a monthly basis. The goal is to understand the accounting, find additional non-recurring items, and understand the trends and story of the business.

The majority of QoE work is accounting, but you can't understand the accounting without understanding how the business is operating. We look at top customer trends and vendors. Did they recently lose a top customer? We'll help you think about working capital. We do a cash proof. We go through the balance sheet to understand if there's any unusual balance sheet accounting that impacts your earnings, like building a reserve in the prior year that you released to the income statement in the current year. Non-cash income that you don't want in your valuation. We look at related party arrangements. A very common one is owning real estate in a separate entity that you rent back to the operating company. It happens all the time, and it's rarely at a market rate.

A common question we get asked is, "Can we do half of this or a quarter of this?" There's real risk associated with not looking at all the parts of the financial picture. The scope is designed to cover the risks associated with what could happen in the next 12 months of earnings. Do the quality of earnings, do it right, and have your advisors look at everything that's needed.

Mike: There's a lot of marketing around this, and we're guilty of this too. There is no such thing as QoE light. It is a marketing term. The same level of rigor we give a big deal, we give to small deals. There just isn't as much stuff to look at. If you get some slimmed-down couple-thousand-dollar offer to do QoE and you think that's enough to buy a $2 or $3 million business, I'd be highly cautious.

What's the range of a quality QoE? Make sure the scope of work makes sense for the industry you're focused on. Your QoE provider should walk you through why they do each step. When you get the deliverable, cross-check every single step of what they were supposed to do. Even with all the AI and Excel-based tools we can use now to fast-track some reconciliations, there's still a pragmatic view of business that just takes time.

We're fixed fee. You'll get QoE from us on the buy side between $15K and $20K. Here's our commitment: we bill half up front as a retainer. If the deal falls apart for something we find and you walk away, we don't send the second bill. That's our commitment on broken deal fees.

Adam: A few observations on finding the right advisor. Make sure you agree on the actual scope, with a detailed list of procedures as an appendix to the engagement letter. When you're debriefing on the work, ask the questions. Understand everything that was performed and the results. Also ask who is doing the actual work on the deal and what's their experience. Just because someone's an accountant or a CPA or an auditor doesn't mean they have the same level of deal experience. Deal size matters, industry matters, and the amount of deals they've done in that industry matters.

Mike: Everyone in our diligence team comes from the Big Four, bar one person who came from a very strong investment bank. These are real, pragmatic, unbiased accounting nerds doing the work. We're not schmoozy. We're not fun to talk to. You don't want to have fun with us. You want us to find the things. Information asymmetry is the name of this game. You came to this conference to find out the steps to buying a company. Our job is to take and find out as much as the seller can get us and back into what we think may or may not be the right numbers.

Adam: The deliverable format gets talked about a lot. Is it Excel? Is it a PDF? Both? From our experience, the deliverable format doesn't matter as much. It's all about the content and making sure your use of the deliverable is aligned with the expectations of investors, the banks, anyone that will need to see the quality of earnings. Ask for an example. We see different deliverables in the market, some easier to follow than others. The market has been shifting more towards Excel-based deliverables, and we're seeing it more widely accepted on bigger and bigger deals as well.

On fee structure, smaller deals are usually agreed to on a fixed fee basis. Bigger deals are usually rates and hours, with a ballpark estimate. Know what you're signing up for. Find a partner that's going to help you through the whole process. As part of our firm, we do bookkeeping, tax, fractional CFO and controller services. We're not there to just send you a quality of earnings and never talk again. If you need help through the process from QoE to closing, we're there. If you need post-close support, we're also there.

Mike: I want to make sure everyone realizes we want to be careful. The two people who lead the recurring CFO and controller practices are over there. The level of SEC and private equity CFO experience between them and that 40-person team is very significant. I don't want you to think we're going to bias your deal to close so we get your follow-on work. Don't call us until it does close. If you want to talk shop on the QoE, that's different. We'd never blend that line.

Q: What's a common add-back issue you see?

Adam: Something that shouldn't happen but does too often is adding back expenses that literally don't exist. It happens all the time, and it's usually not intentional or fraudulent. It's a misunderstanding of the data that's the starting point. The adjustments on the page are based on, "Oh, yeah, I spent $400,000 on vehicles last year for me and my wife. Let's add that back." But what the seller or broker doesn't realize is that your tax accountant capitalized that $400K of expense onto your balance sheet, so it's not even in the net income or EBITDA number that's the starting point. People also add back distributions or anything of that nature. If there's a big bridge between reported EBITDA and adjusted EBITDA, ask the questions so you understand the nature of the adjustments and where the expense sits in the income statement.

Mike: There are lots of add-backs that make sense when you see a SIM. You probably don't need the private jet, the personal travel. The ones that really get to us, especially for service-based businesses, are when they say things like, "You don't have to give bonuses anymore, and you can let go of a third of the staff." If that's true, why haven't you done it already? Although your bonuses might not be contractual, what are you going to do when your plant manager doesn't get his bonus? Are they really going to stick around and keep kicking butt for you? That stuff's nonsense.

The bulk of stuff we find is error. Not everyone is malicious. Most sellers have a reason they're selling. Hopefully you find the right ones. It's a good marriage because when you fund, you're in bed with that seller for some period of time. Something will come back. Hopefully we find as much as we can.

There are a ton of different ways to write your LOI to give you wiggle room. If you put a point estimate in an LOI, no matter if it's right or wrong, people get stuck on it. The real person who should answer that question is Kevin Henderson and Eric of SMB Law because they've written so many good LOIs for this group. These are not investment-bank-created size deals. You're going to get sellers who are selling for the right reasons but don't understand even what working capital is. Honestly, most of you don't understand what working capital is, and that's okay, because accounting for working capital is difficult. It's an inherently weird concept. We'll coach the seller through it. We'll coach you through it. We'll make sure there's cushion built in with your lenders, who also are very astute on working capital and do not want you to fail. Get some working capital on that balance sheet at the time of close.

Craziest add-back story: In the winter just before Adam started, we had a three-year look-back on an HVAC services business, about $6 million in revenue. Great deal. The mom does the books. We were going to include a third period back. We got a phone call saying, "You have to pull this much," roughly $300K, "out of revenue, put it in other income," and then she hung up the phone. No one pulls revenue out. That makes EBITDA lower in that period three years ago. The next time we talked, she pulled me aside on Google. She was in her car. She said, "Mike, are you a dad?" I said, "Yeah, I have three little girls." She said, "Okay, listen to my story." Her daughter, I guess, is very attractive and very entrepreneurial. OnlyFans was new. She had a little fun in college. Mom didn't want her to lose out on the business deductions she'd be entitled to if she started an LLC, so Mom ran that income through the HVAC company but didn't want Dad to find out. To this day, I still want to know what happened. Did Dad ever find out about the OnlyFans revenue that went through his business?

Q: When you bring an add-back that could be contentious to a seller, what's the general response and how do you tackle it?

Mike: One thing I want to make clear: we're a QoE provider. We're here to bat for you on the buy side. Lean on us as the bad guy. "Oh, my QoE guy found this." Keep that relationship as positive as you can with hopefully your good seller. We're happy to be the bad guy.

Adam: The big value gaps are usually black or white. They put an add-back on the page, we've gone through the diligence process, the feedback they've given us is the expense is not in the P&L. That's hard to argue. The gray-area adjustments are usually not the big drivers impacting valuation. Get the seller to agree conceptually with the facts: "Yes, this is not an expense in your P&L, so it can't be an add-back." That doesn't always solve for the revised valuation. There's a lot more emotion and drama that comes with that discussion. Building the relationship with the seller is incredibly important for when that discussion does happen.

Mike: Brokers in this space are not all created equal. They are not all Jackie Hersh. She's amazing. She does her homework. Brokers can be, at best, a nuisance, and at worst, a hindrance to the deal. But getting them over the line is sometimes as important as getting the seller over the line.

Adam: One comment that works well: once they've agreed to the facts, let them know that anyone else who comes and looks at this business is going to find the same thing and come to the same conclusion. We're 80% of the way there. Why put it back on the market looking for the same valuation when you're likely going to get to the same point in another diligence process?

Q: How many deals actually get busted for stuff that you find?

Adam: I wish we tracked that, but it's probably 10 to 20%. Sometimes it's for things we find. Other times it's commercial topics that come up as part of the buyer's diligence. We have an active deal right now where we're 60% of the way through diligence, but the seller refuses to give us the general ledger data. For deals of this size, we get the general ledger data for 100% of deals. He refuses to provide it, which is a red flag in itself.

Mike: There's a larger percentage that fall apart because EBITDA isn't going to turn out. It's 90% of what it was, but you're all buying deals on a multiple. So any dollar lost times that multiple can lead to a retrade or renegotiation, and that's where deals can also go sour later.

Adam: One thing that happens: you may have made a bid on a SIM that's six months old. Once we do the diligence, we're not looking at six-month-old data. We're looking at maybe one-month-old data. If the business has turned down in this six-month period, there could be a very different answer even before you look at adjustments. We've seen certain industries getting impacted by external factors over the last six months. Earlier when I was mentioning, if you don't have recent data when you get to LOI, get more recent data before you spend money on advisors. Add up the numbers, make sure revenue's still trending with where it was, same on the EBITDA line.

Q: Is the GL data not typically outlined in the LOI?

Adam: Usually there's a generic "you're going to support the diligence process" language. I don't think I've ever seen specifying all the stuff you need to get as part of the LOI. This is clearly an example where he's not working through the diligence process in line with what the LOI says. They had the request list when we started. This wasn't a surprise ask. Something has led to them going, "I no longer want to give this to you," which is going to be a black mark against anyone who tries to buy that business in the future.

Q: Is working capital confrontational? We've seen it get confrontational, with sellers wanting it lower.

Adam: Every small deal gets negotiated differently when it comes to working capital. With big deals, there's arguments, but there's a market understanding of how the deal's going to work. There's a normal level of working capital that transfers. The framework is consistent from deal to deal. In small deals, even if you put language in your LOI that you think gets you on the same page with the seller, they may be thinking about working capital differently. Even if it's, "You're going to deliver a normalized level of working capital," the seller may still think they get to keep all their accounts receivable. There's a disconnect between what the seller thinks is going to happen as part of the purchase price mechanism and what you've factored into your valuation.

Q: Somebody who's never done this before, any recommendations on how to figure out what the scope of work would be?

Mike: We'll send you ours. No kidding. We'll send you the engagement letter, the scope, and the request list. Anyone who comes to SMBash gets our generic list anytime they come.

Adam: A lot of people we talk to are having multiple conversations with advisors. If you have three scopes or three engagement letters, you can compare and contrast. The language is usually very similar in terms of the areas the provider's going to be covering. Don't sign an engagement letter that just says, "I'm going to do a quality of earnings for you." What does that mean? QoE has turned into a generic term for financial diligence. You're getting a lot more than just a quality of earnings. You're getting working capital, you're getting the customer analysis. All of that comes with the QoE. Talk to different advisors, get different quotes and scopes, compare them, and make sure you know what you're signing up for.

Thank you so much. Shout-out to the guys who run this thing. This is great. Thank you.