How can quality of earnings reports impact lower middle market transactions?

Patrick McMillan, CFO and Transaction Advisor at Amplēo, is here to share how sellers and buyers can leverage this tool for smoother transactions.

Patrick will cover:

• What is a quality of earnings report?
• Why is it different from an audit?
• How to tell a story with numbers
• M&A trends for this year
• And more

Mentioned in this episode:

• https://ampleo.com/
• https://ampleo.com/insights/guide/sample-quality-of-earnings-report/
• https://www.linkedin.com/in/patrickmcmillan/

Transcript

Patrick Stroth: Hello there. I’m Patrick Stroth, trusted authority and executive and transactional liability and founder of Rubicon M&A Insurance Services. Now a proud member of the Liberty Company Insurance Broker Network. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here. That’s a clean exit for owners, founders and their investors.

Today, I’m joined by Patrick McMillan, Transaction Advisor at Ampleo. Since 1996, Ampleo has provided a part time CFO and outsource comptroller services to small and mid sized businesses. I asked Patrick to join me today to talk about quality of earnings or Q of E reports, and how they can have a significant impact both for the better and for the worse on lower middle market transactions. Patrick, thanks for being here today. Welcome to the podcast.

Patrick: Hey, thanks for having me, Patrick.

Patrick Stroth: Yeah, it makes it really easy with the two of us here. Now, before we get into all things QofE, let’s start with you. What brought you to this point in your career?

Patrick: Yeah, great question. Thanks for asking. I actually started my career while I was in college and accounting. I did not study accounting in college. But just loved numbers. Knew I wanted to do something with them. So I joined a bank and started doing some accounts receivable for them. And then I moved out here to Utah.

And around 06, got picked up by a group of companies as their corporate controller and acting CFO. We had several restaurants, franchises, some, some fun centers. And so dealing with, with all of the mergers and acquisitions, just through that buying and selling kind of got me a little interested in it, but not knowing what in the world I was doing. So fast forward, then I actually started consulting for a few of the people I met in that route.

And then one of the people I met was consultants who later became a partner with Ampleo. Back then it was called Advanced CFO. And so we just kept in touch through the years and a few years ago joined them. And I love it. I haven’t looked back since. So it’s been a blast.

Patrick Stroth: It’s great. You know, there are a lot of people that you know, started in banking and start with numbers and then get out. You’re one that started and stayed in, so good for you. Now, as we look at Ampleo, let’s talk about Ampleo. First of all, I mean, how did you come up with the name because there’s not a Mr. Ampleo that founded it.

Patrick: No, it’s like you, like you mentioned. Ampleo is our name. We used to be called Advanced CFO so we’ve never carried the name of a founder or a partner or anything, you know. Unlike law firms or things like that. The reason why we wanted to change our name a couple of years ago, as I mentioned, we used to be called Advanced CFO, we do provide CFO services.

But through the years, the CFO name itself has really kind of lost a lot of value when a lot of people, especially nowadays are asked, well, who’s your CFO. Like, oh, that’s the person that does my accounting. It’s the one that you know, runs my numbers for me. So it’s really lost a lot of what it truly means. So, as Advanced CFO, we wanted to really differentiate ourselves.

We amplify resources. We are strategic CFOs. We’re financial advisors, strategic individuals first. And we just happen to have technology, strong accounting skills. And so we rebranded as Ampleo to really help clients and others understand that we are the ones who are set apart from the others. We are the true CFOs.

Patrick Stroth: Alright. And the reason why we’re here with this, on this topic, and where it really struck me was when we had the conversation on the quality of earnings reports and just a huge impact they have, quite frankly, because in the lower middle market, you don’t have a lot of companies with audited financials. Well, this is the stress test that they have is this QofE device. So to get real basic before we get into the QofE, how is it different? What is the QofE and how is it different from an audit?

Patrick: We get asked that quite a bit, Patrick, so I appreciate the opportunity to explain it. So quality of earnings, I’m gonna explain what it is first, then talk about how it compares to an audit. So, quality of earnings, I want to emphasize on those two words. Earnings is obviously you know, what’s the company’s earning. That income or EBITDA is the word that we hear a lot. Earnings before interest, taxes, depreciation, amortization.

But what is the quality of those earnings? How are they earned? What’s going on with the trends of those earnings? So the reason why that’s different from an audit and as you mentioned, a lot of lower middle market companies do not have audits, or even reviewed financials. An audit or review tells the what, where a quality of earnings stills the why and the how. The what meaning what are they doing that is in compliance with GAAP.

So it’s really just kind of checking the boxes. Where a quality of earnings is telling the why are they doing that? Why are they earning certain things? Why do they have certain customers in certain industries in certain areas and geographical locations? Why are they changing certain policies or procedures? And how are they doing that? What’s their accounting team look like? What’s the balance sheet look like? And how is it being, how are the accruals being calculated?

So it really talks a lot about that. And keeping in mind, again, the quality also meaning, what’s that going to look like on a go forward basis. When you’re buying or selling a company, you’re buying the cash flows. You’re not just looking at the earnings, you’re buying the cash. And so you really want to understand how that cash is going to continue on a go forward basis.

And that’s what a quality of earnings really, really digs into. We ask a lot of questions that feels like an audit, but it’s not quite as abrasive as one. And there’s just a lot of good questions and communications back and forth with it.

Patrick Stroth: Yeah, and I think that’s at the core of M&A when you’re looking at a potential target, or if you want to be sold, is not what your value is today. What is your value for us down the road? And you know, that’s the story that needs to be told. And, you know, you described it and I like the way you described a Q of E report is, it is, you know, telling a story with the numbers. Can you expand on that a little bit?

Patrick: Yeah, definitely. So a Q of E will really talk about the numbers and what the trends are with those numbers. You know, so for example, and I’ll just use customer concentration. For example, if you have a large concentration on your top two, or three, or even, you know, customers or even your top 20% is by, you know, a small concentration of customers. Then that’s not really high quality, because that story is telling that if you lose a customer or one of these big customers, you’re toast. And it also tells a story of on the balance sheet, you know, how’s your inventory being calculated? What’s going on, what happened in COVID? What happened post COVID? What are those inventory numbers?

And so as a seller, you’re gonna want to not only understand that yourself what you generally do, but you’re gonna want to be able to tell that story in a good lens, so that the buyer can understand and not say, holy smokes, you have a whole lot of inventory from COVID. What happened? Well, that quality of earnings will really help to tell that story in a good light, so that you can understand.

And as a buyer, you’re going to want to know how that story is told so that you can understand what to do. I’ll give you a great example. Patrick, we I was representing a company that was buying another one. And they had, they’re selling protein powders, they had just gone from a, they just opened up a 20 count inventory SKU. Their primary was a 40 count, and they have bought a ton of those 20 counts because they were thinking they’re gonna blow these out. Their sales were low. Super low.

And so with the quality of earnings, we actually helped them even from a buy side, we helped them identify, well, rather than write off all this inventory, because it’s going to expire before you’re able to sell it. We said, hey, what if you use those 20 counts used to fulfill your 40 counts. And just tell your customers, just add them a note and say, hey, listen, we’ve got some of these, we’re gonna give you two bags. And your benefit is you only have to open one bag at a time.

So we’re able to really identify those things and tell those kinds of stories and also help you to understand what those numbers mean, and how you can really interpret those on a go-forward basis. That way you can understand what your true EBITDA is because most companies are bought on a multiple of EBITDA. So we really help you identify what that true EBITDA is with that story.

Patrick Stroth: Well and are you engaged largely by sellers looking to sell before they go to market? Or is that just you know, buyers have a target and the target is not audited. They don’t have reports. And so this is part of the diligence process for the buyer. I mean, what’s the split on that?

Patrick: You know, it’s been very interesting. When we first started this a few years ago, we really saw a whole lot of buy side. You know, they were coming in, they had a target identified and they really wanted us to help them to understand that story and the numbers. Now we’re seeing that flipped quite a bit and it’s almost a 50/50 and maybe even more of a 60/40 on a sell side.

Because the compression and evaluations we’re seeing a lot of sellers have to be able to tell that story, as you mentioned, and they can really do that with a quality, a sell side quality of earnings that helps them to have that strength number one. And number two really induce that confidence. And so we’re seeing a large fast heavy swing over to a sell side.

Patrick Stroth: And, you know, in my opening, I mentioned that, you know, these can, you know, benefit or work the downside. You know, depending on how the report comes back. Describe both sides of that, and then how sellers can go ahead, because we do a lot on the sell side. How can sellers leverage this tool?

Patrick: Yeah, definitely. So the benefit is really, if you’re, I talked to someone earlier this week who, in COVID, they made a significant change in their business, and wanting to really understand how is a buyer going to look at that. Well it’s not really a continual business for them. And so they’re thinking, oh, my gosh, we’re gonna have to add all this back. And we said, you know, what, we can help you to tell that story and understand how a buyer is going to look at that and really present a picture that you as a founder, are able to adjust according to market conditions, and economic conditions.

So that’s something that’s good. On the bad side, a lot of times from a buy side. Oh, man, I’ll tell you a story. We were representing a buyer. And on the I was talking with the target and kept asking now, what are some management add backs? What are some things that you feel are non related to the business or noncontinual items that should be added back? Nothing, nothing. I don’t think we have any of that. So that’s great.

So I went in and found some of the add backs that are pretty normal. And then right before I’m able to deliver a draft, they came back and had this laundry list. Oh, what about this? What about this? And it’s like, they were just shooting from the hip, just trying to beg for as much as they could do. And that really turned a buyer off quite a bit, because they’re like, you know, wow, what are they? What are they trying to cover? What’s going on here?

So I really had to help understand both sides and see where they were coming from. It was a very difficult deal. I don’t believe it ended up closing, in the end, because there is a lot of trust issues, and not just on the numbers, but on a lot of other things. But I was you know, very interested.

Where so if you engage us long before we can walk you through or what the buyer is gonna look for, we can really help you to understand, you know, how to look for those management add backs and present those in a way that a buy side is going to really understand and have some strength to it.

Patrick Stroth: You know, I think that your earlier work on the buy side, educated you guys and gave you the experience, so you know what they’re looking for. And you the red flags that they’re going to be very sensitive to and how though, you know, what are the appropriate responses to those. So is this a big problem or a little problem?

Patrick: Yeah, we’re able to educate the sellers, as we’re talking with them, too. We help them to understand what their earnings are from a buyer buy side perspective,

Patrick Stroth: Well and you mentioned now the sellers are coming and reaching out to you well in advance. Talk about the onboarding procedure that you guys go through to Ampleo. I mean, what’s involved in it, and we can’t get around cost? So if there’s a ballpark cost for engagement how does that look?

Patrick: Definitely. So a typical engagement will start out, you know, someone reaching out to us, and it’s pretty much by referral. All the business that we get is by word of mouth referrals, you know, repeat CEOs, repeat founders, repeat private equity, investment bankers, business brokerage. You know individuals such as yourself. You know, they’ve either engaged with us before, or have spoken with someone who has engaged with us.

So they’ll give myself you know, or someone a call, we’ll chat with them. We’ll you know, get on a Zoom call for two or three times. 30 minutes or an hour at a time and help them kind of discover what it is that they’re doing, understand the business, what they’re looking for, what their goals are. And then that will help us to understand more about how to scope the quality of earnings.

Because there’s really kind of the quality of earnings light, and then there’s the quality of earnings heavy. And then it really depends, a lot of it will depend upon, you know, what the size of the business is. I mean, our sweet spot is really that two to 50 million in revenue. We’ll go up to 100 million in revenue. We won’t go anything more than that. We’ll leave that to the big guys who will charge $100,000 plus.

I’ll talk about our costs here in a second. But we really serve that lower to middle market. It’s the underserved market that we are the subject matter experts in. We have tons of experience, we have a large team. And so after that discovery call, we’ll send them an engagement letter, they can take a look at it. We’ll have the entire scope on there. The fee process. And then once they sign that do a 50% deposit, again, I’ll talk about costs here in a second.

We can start that day or the next day. We have a very, very deep bench. We have great individuals who know the industries and who can jump on real fast. And it typically takes about four to six sometimes to eight weeks from beginning to end. And we’re talking with them throughout the whole process. Giving them weekly updates. Asking a lot of questions, giving them flash reports.

You know, whether it’s a buy side or sell side so such that they can understand what we’re seeing. We’ll even open up, you know, a call and say, hey, here’s the kind of stuff I’m finding. Walk me through this. So regarding cost, as you mentioned, you know, it’s for us, and I’m going to go from bottom to the top.

Really the bare bare minimum that you need to have that confidence, that earnings match what the economic representation of that company is, you have to have a cash to revenue proof. And if that’s all you want, if you’re a small company, you know, just a million or two, and that’s all you need, or all you want, then we’ll charge you 10 grand to do that. So that’s, you know, super small, something that we can jump on real fast and get done.

It’s basically, that’s matching your bank statements to your reported revenue. Backing out any non revenue deposits from the bank statements to make sure that they tie together. We have a quality of earnings light, that’s, you know, that’s pretty slimmed down, that are typically around 20 grand or so. And then we have a quality of earnings heavy, that’s got everything. It’s got inventory, you’ve got add backs, you’ve got multiple entities, you know, and those, we are typically around 35 or 40.

Our average, Patrick, I mean, out of all, and I keep stats and all this. Our average quality of readings is $25,000. Then when you’re looking at other, you know, other I guess top 11 or 10. You know, instead of Big Four, we kind of have the next eleven. You know, I guess is what people are saying. They’re typically 70 to 90,000 plus.

Patrick Stroth: Wow.

Patrick: I saw a report yesterday, and I won’t mention who the accounting firm is. But their minimum fee is 200,000. They won’t touch anything, unless they’ll charge you 200,000 for it. So when you think okay, well $25,000 for a lower middle market, that is outstanding. And the quality that we give, and I hope that you provide a link please, to our actual sample of quality of earnings that I sent you because we want that to get out there. We want people to see what a QofE actually looks like. Because a lot of people hear about them and a see kind of some reports, we want to show you what a full report looks like.

Patrick Stroth: Actually, we’ll make sure we have that link in our show notes that are going to be attached. So that won’t be a problem at all. And you had already given a kind of a profile of your average client. any industry or geographic region that you can fine tune for us?

Patrick: Yes, we’re actually industry and geographic agnostic. But I will tell you kind of some of the concentrations we’re seeing. Geographically we’re not seeing a ton of concentration. We are based in Utah. We have clients all over. I’ve actually only seen a few of our quality of earnings here in Utah. We have a few Utah based clients that we do serve specifically. But I mean, currently we’ve got several reports, and I think actually none of them are based out of Utah right now. As far as industry goes.

E-commerce and services are just hot and sexy right now. So we’re seeing quite a bit of those that we serve. We’ve done quality of earnings in so many industries right now. Manufacturing, we’ve actually done, we’re doing one in energy right now. We’ve done a few of those. Service providers multi entity. We’re getting ready to kick off one of those in the next week or two. Crypto and blockchain, agriculture farming. I mean, so we really serve about any industry.

Patrick Stroth: Well that’s solving a mystery if you’re in the crypto area.

Patrick: Those are pretty crazy. We’ve got a handful of amazing CFOs who are just oh man, let me tell you they’re top notch in that kind of stuff.

Patrick Stroth: Well, business is good and is booming if you’ve got a segment of your community that is only dealing with $200,000 plus engagements, which is a reflection, I guess, on there’s a robust M&A community out there and deals are happening quite a bit. And a lot of that acceleration in the last couple of years is we credit it to the insurance industry.

Because there’s now a way that you know, risk can be transferred away from the two parties off to an insurance company. It’s called rep and insurance and it’s had a huge impact on not only the safety of deals, but the speed the deals happen. But you know, don’t take my word for it, Patrick, good, bad or indifferent. What’s been your experience with rep and warranty insurance?

Patrick: You know, it was it’s very interesting, Patrick. And that’s one of the reasons why I reached out to you because I didn’t, I had not had any experience with it. I’m very familiar with the reps and warranties you know, on purchase price and everything. And I’ll tell you why that is a very strenuous conversation from both parties, especially when you have the attorneys involved. And so to understand, you know, someone like you that provides a service like that specific to the sell side, I tell us, that is huge. And that’s why I’m going to be talking with a lot of our clients about that. So I like that.

Patrick Stroth: That’s what’s been great is this product, essentially, what happens is it takes the seller reps, that the buyer is performed diligence on, and post closing, if it turns out those reps were inaccurate, and those inaccuracies lead to the buyer losing money, the buyer through the purchase and sale agreement, the terms of the agreement can claw back some of those lost funds from the seller. Sellers don’t like that.

But that’s part of the agreement. It’s called the indemnification clause. Well the insurance industry stepped in and said to the two parties, tell you what, show us the reps, show us the diligence. And for a couple bucks, you guys don’t have to fight over each other come to us with the loss and we will pay the buyer. And that’s been a real elegant solution.

The newest evolution of reps and warranties because this product was reserved for deals priced at $50 million and up. So it was under extremely strict diligence requirements to be able to be eligible for the coverage. That left out a lot of smaller deals that are in the literally the one to $30 million enterprise value range. Even if they wanted the coverage, they couldn’t get it. There’s a new product out there called TLPE. Transaction liability private enterprise.

And what it does is it ensures the seller, the seller is the policyholder, against claims brought against them from the buyer for a breach of the reps. And the nice thing is we underwrite the seller. And if the seller receives notice from the buyer, seller doesn’t have to respond. The seller just forwards that notice of a breach to the underwriters and the underwriters negotiate settlement with the buyer.

And at a cost of $15,000 per million dollars in limits, okay, it is just a bargain for both parties involved. And quite frankly, while the seller usually pays for it, there are a lot of cases where the buyer wants to contribute, and they’ll split the cost. So it’s been a very, very nice evolution as this market has matured.

Patrick: That’s huge. I’m sorry to interrupt you. You mentioned that they want to see the diligence. And so there again, it’s absolutely vital that they have a solid diligence report or quality of earnings. Yeah.

Patrick Stroth: And you cannot go forward without it right now. And that was actually an easing of the restrictions. Original rep and warranty policies four or five years ago, the financials had to be audited. They weren’t audited, you know, the rep was ineligible. So quality of earnings has definitely been a very, very useful tool for underwriters. And going forward, we can see it now, with the smaller deals where they’re getting quality of earnings reports, and it’s a great, I’d say risk mitigator. So you get more favorable treatment from underwriters, when you have a QofE report.

Patrick: So it’s almost like a double risk mitigator, because that QofE really helps you number one mitigate that risk as well. You wouldn’t buy a car without taking it to a mechanic. You wouldn’t buy a house without getting you know, several different types of inspections. Well, you wouldn’t buy a business without getting a good solid due diligence of everything, and particularly the financials, because why are you buying it? Financials. Cashflow.

Patrick Stroth: And that’s the bottom line on this. And that’s the source of most claims for rep and warranty policies. You know, the financials weren’t completely accurate for whatever reason. And those inaccuracies, if they cost the buyer, that’s what the policy pays. So it’s been a very, very, over the test of time that we’ve had, it’s been a very, very elegant solution. And underwriters pay claims a lot faster than under any other policy. So it stood up. So we’re very, very proud of it.

Patrick: Nice. Nice.

Patrick Stroth: Yeah. So now, Patrick, as we look forward here in 2023, we’re about halfway through. What trends do you see for the rest of the year, either, you know, macro, or just with Ampleo?

Patrick: Yeah, I’ll actually start out with our trends in Ampleo. And then I’ll kind of you know go out into the market. So we are growing quite a bit. We have over 120 consultants now, you know, nationwide, like I said. So we’re, you know, people are really understanding the need for that true CFO, and so we’re grateful to be able to jump in and help out and on many different levels. We’re growing. We’re seeing our clients grow, yeah. We’re seeing some compression in valuations.

However, we’re seeing a lot of growth in numbers, you know, and that’s really getting solidified. And that’s something that we really, really like. I’m seeing a lot of return to normalization is what a lot of people are hearing. You know, people are like oh my gosh, compressing values. I was supposed to get a 12x EBITDA. Now I’m gonna get a 4x. You know why? Well, guess what, that’s what it was pre COVID.

So you’re just back to that, and you probably got a COVID bump anyway. And so we’re just kind of seeing some normalization there. And that’s something that I think is vital and important. We’re seeing a lot of something on the quality of earnings site itself that I’m really seeing a lot is that increased skepticism and scrutiny.

You know, so rather than trying to throw, you know, a whole lot of add backs, you know, from a sell side and see what a buy side will recognize, no let’s actually understand them. And really make sure that both sides have that confidence in each other. So that’s a big, huge, huge change that we’re seeing. So that’s why it’s important to have an expert like us really understand how to do a QofE. Whether it’s a buy side, or a sell side.

Patrick Stroth: Outstanding. Well, Patrick McMillan from Ampleo. How can our audience members find you?

Patrick: Yeah, a few different ways. Go to our website ampleo.com. We have a lot of resources there. We’ve got some blogs, glossary items, some guides. You know, there again, like the quality of earnings guide, or sorry, the quality of earnings report our sample that you can download there. You can look me up on LinkedIn, Patrick McMillan.

That’s spelled M C M I L L A N. Actually, I have just set up a website, that can just direct you to my LinkedIn. Just qofeguy.com. That’s the letter Q o f the letter E g u y.com. That’ll direct you right over to my LinkedIn. People know me as the QofE guy, so I figured why not?

Patrick Stroth: Perfect. Great, great, great. Well, that’s good branding on your part. Well Patrick McMillan, thanks very much for joining us today. It was great talking to you again.

Patrick: My pleasure. Thank you, Patrick. Appreciate it.