Most QoEs Miss 50% of the Work & How Guardian is Better - Presentation at Harvard Business School (HBS)
In a recent presentation to the ETA Club at Harvard Business School (watch here), Elliott laid out how ETA & SMB QoEs are different and how most providers miss 50% of the analysis. 50%!!! How? They miss that for smaller deals, half of the QoE should be focused on the operation of the business and how they create the EBITDA or SDE.
Most providers have no clue how to connect the two.
What You’ll Learn in This Post:
QoE Diligence for ETA & SMB deals is 50% Financials and 50% Operations (the part that everyone misses)
The key Operations questions include: Are the Operations able to sustain consistent EBITDA and SDE & How should the Buyer think about necessary Operational changes to COGS and Operating Expenses.
You cannot spend EBITDA or SDE at Wal-Mart. BE SURE TO CONVERT ALL FIGURES TO CASH FLOW AS PART OF YOUR QOE
Let’s start with the key issue of QoE & due diligence for smaller deals: 2 critical jobs must be done but there is only budget for only one.
The 2 jobs:
Financial diligence or QoE: How close are the financials to what was presented in the CIM & making sure there is no fraud.
Operational diligence: How good are the internal people & processes at generating consistent leads & new business and subsequently delivering the product or service at high quality
The SMB QoE must get these 2 jobs done inside of a $20-$30k budget?
The Half Most People Pay For & Accept:
QoE providers won’t tell you they’re only doing HALF the work on ETA & SMB deals but that’s the truth! Evaluating financials alone is like navigating with only half a map. Unfortunately, plenty of Quality of Earnings (QoE) products on the market fail buyers. How?
Smaller companies are hugely reliant on the Owner who is leaving
Employees doing 2-3 jobs which is not sustainable
Operations are more complex than larger companies.
With no focus on Operations and the sustainability of EBITDA and cash flow these popular QoE solutions are leaving you HIGH & DRY.
Guardian does 100% of the work. We look at the Financials and then analyze the Operations to provide insights into the sustainability of the business - the REAL question Buyers seek when they do a QoE. What does it benefit you if the Company did $1 million in EBITDA last year but will only do $500k next year (the year you’re buying!)? We help discerning buyers investigate critical areas like revenue, cost of goods sold (COGS), and operating expenses. Plus, we’ll never forget (like some providers) to report on cash flow so you’ll know you have the reserves you need.
In this blog post, we’ll take you through the RIGHT way to use your QoE to help you make a strong business buying decision.
Why Quality of Earnings Alone Isn’t Enough
In ETA deals, looking at the financials is not enough. You simply can’t separate the financials from the operations of the business. If you do, you’re missing half of the picture.
On a larger deal, financials may be enough. There, the financials are a function of a top-class management team and a very competent controller. However, when you’re looking at SMB deals, you can’t trust any of it. You have to consider whether the operations of a Main Street business or a founder-led business mimic the presentation of a top-level company with good financial stats. The reality is that they probably don’t.
Distinguish between what you see in the financials and what you actually believe. For example, a 40% growth in a Yellow Pages business from 2022 to 2023 obviously doesn't make any sense. AI talent at a lower cost also doesn’t make sense. You need to do a gut check and ask yourself whether the numbers make sense in the context of an operative business.
Here’s a better approach than purely looking at financials.
Collect QoE financials
In your deal evaluation process, use the Quality of Earnings (QoE) as a basis of your understanding of a solid financial set. That's the accounting and business acumen that you might already have. Start with that common language.
2. Identify the key drivers of EBITDA
After you review financials, you need to identify what key factors drive EBITDA.
What are the biggest revenue drivers?
What are the biggest cost drivers?
What are the biggest risks?
Get yourself seated in the mindset of what you need to know to win in this industry.
3. Develop an opinion on the sustainability of these drivers
Finally, take a look at the sustainability of these key factors.
QoEs look at historical data. Is anybody buying historical cash flow? Nope. We're using historical data as a proxy for what will happen going forward, but you need to keep in mind that sellers will try to boost the most recent period to sell at a high multiple.
Much of what’s reported in the most recent period will probably be inflated. Brokers and bankers are really good at making financials look great. And everybody in the deal is good at telling a story about it. Listen to what people say, but be skeptical and then find out for yourself.
Ask yourself if what you’re looking at is sustainable.
Get Revenue from the QoE, Then Evaluate Sustainability
You can probably define revenue in twenty different ways, but to me, revenue is a function of salespeople, the sales process, and the quality of the product or service. Examine each factor.
Salespeople
Find out who is actually selling the products or services. The current owner might tell you about their top salesperson or account manager while they are actually relying on their own personal relationships to bring in revenue. The owner will always tell you that someone lower down in their organization is selling, with some spreadsheet to back them up. That’s a risk that the seller probably won’t be upfront about.
Sales Process
You also need to consider how repeatable the sales process is.
For e-commerce and some online businesses, you will get pretty good data through their dashboards. For example, return on ad spend. Amazon will give you data. In digital marketing companies, you can get this information.
The home services companies—that are so interesting to everyone—are a different story. How do you know how repeatable their sales processes are? They will claim they’re making sales through word-of-mouth or referrals. They may even say it’s their website, and when you go to the website, it’ll look like something from WordPress in 2002.
You have to dig into what the real sales process is and whether that will be repeatable.
You might be a funded searcher who has to go through your investors to get this deal done. You might be a self-funded searcher, and you're going to kick the seller out and have to do it yourself. If something goes wrong, you’re under a personal guarantee. Either way, you need to know whether you can successfully sell the products or services of the business.
If you don’t have the skills or knowhow to sell the products or services yourself, the level of scrutiny you need to have around how they’re currently being sold is higher.
If you can sell them, the current sales process might not be as relevant. I have some clients who are salespeople or are experienced running sales processes. For them, it’s not as critical of a diligence issue.
Quality of Product or Service
The other side of revenue is the quality of the product or service the business is selling. There are many reasons why sales might be low, but what if the product just sucks? What if the service just sucks? There's no way to oversell a terrible product.
When you think about revenue diligence, you have to think about more than the $5 million or $10 million in revenue that some QoE provider is telling you about.
You need to think about:
How does that number build out?
Who did the work?
How good is the product or service?
How is it priced relative to other products or services in the industry?
All these things help you understand whether you will be able to sell as well as the previous owner when you get into the business and have no help.
Get GOGS from the QoE But then Evaluate Sustainability
Cost of Goods Sold (COGS) is similar. It will be a function of raw materials or platform costs and labor.
Raw Materials or Platform Costs
The questions about raw materials or platform costs that you need to ask are:
Who are you getting raw materials from?
Is it an arms-length transaction? Often, sellers have buddies from high school, business relationships, or other connections that help them get better pricing than anybody else would ever be able to get. That can hit your COGS by 10% and your EBITDA by 50%.
What are technology platform costs? A lot of these technology platforms are raising prices. Are you right ahead of a technology price increase?
Are there tasks that the owner or some marvel in the company is doing that you would need a technology to do because you’re not an expert?
Labor
A lot of small businesses don’t do COGS at all. Everything’s operating expenses. On a $10 million transaction, no one will really have a tracking system on allocation of time dedicated to direct product or service time versus admin time versus vacation time.
You really have to think through each aspect. Gross margin might look great, but the data might not even be accurate. That's not necessarily a malicious thing. They’re not trying to lie to you. It’s just that private business owners have no reason to overinvest in accounting to make it easier for you to buy the company with accurate information.
Get Operating Expenses from the QoE but Evaluate Sustainability
Operating Expenses will be a function of both overhead and efficiency.
Overhead
Oftentimes, we look at similar companies—either public ones or IBISWorld—to understand what the overhead percentage should be. This is similar to COGS where there’s no telling what’s in overhead or what’s not.
You really have to be careful about the seller who's doing three jobs or the owner's partner—wife or husband—who “doesn't really work in the business” but does everything in the business. What would their roles look like when you take over?
Efficiency
Could you be more efficient than the owner? Everybody wants to believe that. I hear it all the time. Buyers will say that they plan to add technology to make the business more efficient.
You should not think that the owner who has been working in this business for 20 or 30 years—taking home everything that he can—would be spending money frivolously. That should not be your opening position in how you think about these deals.
If anything is inflated, you should wonder if it is just harder to do than you think.
Always Convert EBITDA to Free Cash Flow
Around 80% of the QoEs I see in the market don't even convert EBITDA out to free cash.
This is a key piece of the analysis that you either need to be able to do yourself or have your provider do for you. On some of these $5,000 or $10,000 just-checking-boxes QoEs, this information won’t be in there. It can screw you. You might not have enough cash flow to pay yourself, make your planned improvements, or even pay off your SBA loan.
This impacts asset-heavy deals as well as deals with bad AR versus AP. Deals with bad debt expense. Deals with long work in process cycles like construction. Know your potential cash flow before moving forward with any deal.
How Guardian Does It Differently
Many of the concerns raised here can’t be answered in a spreadsheet or on a Zoom call. You need to go sit with people. You need to go talk to folks. You need to talk to industry experts.
Traditional QoEs are an accounting tool. The way I think about them as a deal professional is that a QoE has to extend to almost full diligence for an ETA arrangement. In these deals, buyers don’t have $150,000 to get advisers to help in all of these different areas. You have to ask the right questions or have your QoE professional do it for you.
If you’re looking for the kind of comprehensive deal support that will get a great deal done, you’ve come to the right place.