hi everyone and welcome to our second webinar in our M&A advisory series quality of earnings before we go ahead and get started there are a few housekeeping items I want to go over so just so you know you can maximize or minimize the webinar pain during the presentation by using the red and orange arrow buttons during the webinar we definitely encourage you to ask questions our presenters will answer those questions as we go along or at the end as time allows and then also I want to make sure everyone has good audio so if you're using a telephone make sure you click on the phone call audio option and if you're listening through your computer then go ahead and click on the computer audio option and then just as a reminder we are on social media so be sure to follow us on Facebook Twitter Instagram and LinkedIn and today we have two presenters and have Dinkley ombo who after spending 12 years as an auditor and our audit department here he transitioned to our chief relationship builder for the firm he's helped numerous private public and nonprofit companies address their tax audit outsourcing accounting needs we also have John Dunnigan who was a partner in a CFO advisory service practice with more than 30 years of financial operations and consulting experience with public private companies so with that take it away guys awesome thanks so much Marie and we're excited to be here like you said this is part 2 in our M&A webinar series the first one was all focused about GAAP financial statements and how those were used today will be quality of earnings you can see that in about a month we'll be talking about the importance of completeness of Toxic rules in the M&A process will also go through equity and valuation as well so we're excited for today today we have John Dunnigan partner and our CFO advisory group here to join us to talking about it we're great at mourning again maybe that's right depending on where you are John is joining us from Dallas today so we're really excited about that thanks John ok as we could see first off let's get started here you can see the state of the market they're still definitely why are we doing this webinar because there's a lot of strength and B in the in the markets out there for q and A's especially you know up to 2017 lots of vc-backed exits and we're still seeing a lot of that going on here I'm going to get to the 2018 here you can see in 2018 deal sizes still remain elevated we haven't seen deal flow here in 2018 and the valuations in our own client base that are being acquired are pretty high John are you seeing the same thing right now and your current workload I am yeah it was very busy a lot of transactions going on so the act then the markets still very hot it seems awesome okay here so the next slide yeah so because of that you know some deal count is down a little bit but again the valuations are high which is making it a little bit more challenging I think people want to get that the highest value as always so hopefully we can talk about that today with regards to what that looks like for two nice so quality of earnings John why would you need one walk us through this why did why would someone need a quality of earnings report so there's a number of reasons reasons to do it and we'll talk about a lot a lot in this morning but primarily it's really most transactions are still driven by multiples of EBIT that's usually kind of the biggest one of the biggest factors in it and what it really does is companies or buyer wants to know what a normalized even thought looks like how is this company done historically obviously it's backwards looking it's not fair looking but they want to understand understand the business that's a really what quality of earnings focuses on it's very much a PL PL focused activity and then report and the other piece of really kind of focuses on is working capital will touch on that a little bit but that's really what it's focused on because at the end of the day most buyers are buying they're buying the future operations of the company but they want to understand what the company looks like and it's different in the north in some really kind of key ways the first is they know here quality of earnings report is management derivative which is to say that the buyer really dictates what a quality of earnings report will focus on da and I are talking yesterday in the preparation for this one you know one of the quality of earning reports not really full quality of earnings reported working on but the buyers only interested in looking at revenue of the other target company that's all they want us to look at so you know further on it you need to as you all I'm sure aware you need to have you know meet minimum standards to complete an audit an issue an opinion of work that needs to be done activities need to be followed turnaround as part of the audit not so the quality of earnings we can do as much or as little work as the buyer and seller really agree on real us to do that's kind of in for the first big difference the second difference I guess is really that is they said it's very its P&L focus we're not we're generally using management's information although we are testing it to some degree we're not doing the kind of independent testing and verification that you do it and on it so we're not issuing an opinion monkey doing an audit so there's no attestation though it no independent opinion issued as a as a part of a quality of earnings as I said it's really focused on EBIT da which is earning before interest appreciation and amortization and actually should be interest taxes depreciation memorization forgot one forgot the T there I just realized the reason reason they use these dogs is it pretty much approximates cash flow and that's that's it's kind of a shorthand for the cash from operations that's really kind of what what it does and when we do then is we really normalize that so we're looking at we'll talk about what that means but it's really kind of fun normalize that for for activities that that the companies come be looking at the other thing is we're talking about is working capital a buyer is very focused on very awful working capital it really is kind of position of the company how much cash the company has and very much impacts how much cash the investor or the buyer is going to need to invest in the company forward in the short run for daily operations so working capital is the other there's kind of big focus of of quality of earnings the need nickel is jump to the next slide go ahead I do have a question so it really sounds like this is really a P&L focus type of a look versus you know in a Gap report you have the balance sheet you know statement of cash flows and other things here it's we're really looking at the PML that is that a fair to say yeah that really is a focus the focus is very much on the piano that was she tends to be other than working capital tends to not get a lot of a lot of look at the quality of earnings report you know unless you have a company you know companies heavy capital come like having many facts where something might be different but for most companies know the balance sheet typically is not really not really much of a focus on a quality variance report about it okay okay so what are some of the what kind of Jason was talking normalizing EBIT da what are we looking at so the first thing is you know clearly if they're if they're Corrections for a gap we would we would identify those we usually start with a with an even size reported by the company and then make various adjustments to it and then Dean wants you to click down a little bit of the few there's a few more here we can talk about them okay they said the first is correct you for gap typically you know if the company's audited it wouldn't be any but a lot of times we're working with companies have never been audited so there are so we will correct errors for gap to the extent we find them and that's use the first adjustment but the bigger adjustments typically are the other things you see listed here um you know one-time expenses one-time gains and losses you know one-time gains with or unusual items and these are the things that they want to pull out you'll forget financial statements if you have big let's say legal expenses gain or loss on a sale of assets if you've hired a banker perhaps to help help sell the company or involved with the the company in the sit transaction now those can be some fairly substantial expenses that will be now show up in the P&L um but for and that's appropriate for gap I mean for gap purposes those are actually correct but burnings for quality of earnings are quality we generally adjust those out this is the buyer or the investor wants to see what the company look like kind of on a normal running this morning basis we'll talk about normalized business expenses this is an area where we spend we tend to spend a fair amount of time and what we're looking at here is very often a target company particularly in the startup phase we'll have a lot of people have expenses included not that they're wrong but they are things of the Bayeux will necessarily carry forward there could be extra employees that you know they may not think the company may not need going forward those can be anything from you know if the buyer is you know you know may not need an accounting department in any operation they're buying so it does get adjusted out you will have salaries a lot of times these founders of the business will have more salaries that are not at market as I'm sure a lot of you are aware you know if you're if you're the founder of the business in a lot of times you're not taking any salary at all or you know in case we want to adjust that up we will add back some or normalized salary for a CEO or of the company or CFO of the company or sometimes they're taking you know above market and that's that may be very appropriate from a GAAP point of view but from a normalized business point of view we want to adjust those out likewise a lot of times you know there will be departments that things like maybe a marketing department or sales department or even in a county department that the target doesn't those are really happily stepped out to the degree they should some of those expenses we would add back to try and give the potential buyer investor and Lucy what the company might look like normalized one ring business so those are kind of things were really focused on or talking about it adjusted adjusted Eva tock being that all make sense yeah yeah does it does really what they're trying to do is is get a sense of what the PNL would look like for them once they acquire the company does that make sense exactly yeah that's exactly right yeah they really want to understand not how that is the plenty Mr Wong for GAAP but you know what it would look like on a more normalized basis great and basically at the end of the day this is all to set up that value for what that looks like for them right right that's exactly right what does it look like for the one for the buyer and the investor coming in so what are we looking at and click down here there's a couple more items let's get them all on the screen Oh luncheon video okay so so the first thing we always look at because always the biggest almost always the biggest question a buyer investor has and our trends in revenue they really want to understand what what the business looks like at the top Laurie because that's more often than not what they're really concerned about and you look at things like you know customer concentration product concentration geographic concentration you know does this business you know generally speaking the more diverse the customers and products the better the better the the target company is because there's less risk if you it's the more the more customers the products the less risk you have any one customers don't go to throw that that's for the business out or derail a business if they lose the customer now obviously a lot of startups a lot of times they're the buyer is very focused on obtaining a particular customer or small customer set or particular particular product set what they want to know that too they want to really know if they're really interested in a particular product or customer how much of that of the business overall is tied to that customer product such a very important information from buyer is usually very focused on likewise you know geographic concentration is very important is is the bit or the business or the sales very much us-based North America base what do we have a lot of operations in Europe Asia Africa Middle East somewhere else that somewhere else in the world that they won't understand what that is because we don't know there's certain risks and benefits to having having international operations or jus very geographically dispersed operations and then of course seasonality you know the business highly seasonal or is it as a business or the business growing very steadily and pretty pretty straight and the cost of revenue question really comes down to is the cost of revenue properly tied to the cost of courses cost of revenue are properly tied to revenue is the gross margin consistent or there anything on anything unusual going on in the cost of revenue that they want to make sure they identify unusual unusual cost that might be include in there have to be adjusted and it fully is it a fully loaded cost of revenue so that the company again the by want to really understand what that pop line looks like what that gross margin looks like that's usually the biggest biggest focus and biggest area of concern on it if you want jump jump so John this is really jumping through the details here right that makes a lot of sense the details of the P&L versus GAAP financial statement it really just says is everything properly stated right which could be the case here it's jumping through the details of all the different transactions and trying to really figure out what what the PNL that they would be buying looks like that's right that's right um which is a key point by the word this is different than an audit as you say you know from a lotta t the only questionnaire is is the total revenue properly stated the artists not generally concerned about these kinds of questions and that's bringing us bringing us in to do a quality vernie's really to kind of help the buyer ferret out all of this information clearly i really lay it out for them so not just what the total revenue is but how that revenue breaks down across customers and products and stuff your death to your I team that's really wasn't really what we're focused on here just kind of digging into that level of detail that you don't see in order to financial statements makes a lot of sense okay yeah so some of the other silly help you jump won't be far okay sorry don't worry so again what else what else we looking at appropriate matching up I mentioned it's a little bit you know probably matching across in revenue again and make sure that it's they understand understand the trends operating expenses one of the big questions there is always you know do that for appropriate cut-offs or when you're looking at trends for quality very important I should say that I didn't mention this before but I actually have said you typically were doing these on either a quarterly or monthly basis so I'm like an audit which is unless the public company is going to be strictly an annual numbers the quality of earnings reports are are usually quarterly or monthly so when you're getting much more detail in the trends in individual periods so so that's probably a matching of costs and revenue and operating expenses in the appropriate period something we were always looking at to help them make sure that they're they understand how the business is flowing the appropriate cut-offs in the various periods and it's not just a year-end again what are there any unusual operating expenses I mentioned some of the things we looked at before we've got people being you know paid too much or too little compared to market are there any unusual expenses that are data flowing through there you know a lot of times you know I'll continue see more on or today a lot of times you know owners founders will have you know certain amount of personal expenses and things and the operation issues will pull those out as well any of any unusual items that I've talked about that could be that we might want to adjust for it yeah it's it's about helping the buyer or investor really understands up the flow of the business kind of month in month out and so they can really understand what it is they're buying great great the next slide this is really kind of the more of a working capital side again this is you know some of the big items we tend to look at not an exhaustive list but we're looking accounts receivable are are they are the counter you will really age what do they want is the timing one of the terms on which comes the business is not just necessarily state attorneys a lot of the actually collection terms today are probably reserves for their receivables if they need them if they're aged if you have a company that has inventory that's always an area that gets a lot of focus you have old inventory that's not being written off one of the inventory turns at the product at the individual product level again it's really getting into that that dealing that del L detail it's really going to drive the business going forward and then the liability having properly recognized all cools and liabilities they got everything on the balance sheet that they really really should have on the balance sheet because there's these are the big items that really kind of drives they said the buyer and investor coming in is always interested what kind of funding they need to provide the business particularly the short term I mean they can put a long term financing in place in terms of investors a long-term debt bank debt things like that but a lot of times in the short run and buyers got to come in and put in working capital if they need to do that they want to know what that numbers look like as part of it as part of that planning and part of the purchase price negotiations so if you want to jump ahead there Dean okay so we talked about quality range report you talk about buy-side and sell-side the buy side is mostly what I've been what I really kind of been talking about in the way I've been talking about it that's the buyer coming in and looking at a company they're interested in buying or or an investor that they're looking to invest in what a lot of the work we do is sell side due diligence which is essentially you know one of you on one of you on those on this webinar the site you have is committed to a quality of earnings reports on your own business in anticipation of selling the business and and you might be wondering why why you would do that and if there's a number of reasons to do it and why a lot of couple we'll choose to do it the first thing that you really want to identify issues up front you don't want to if you as you get into working with negotiating with the seller and getting clean closing the deal you don't want things coming up at the last minute you don't want surprises obviously the seller doesn't either books you need the buyer doesn't either or the seller you want to make sure those things are those things you're upfront and you want to understand them what they are because the buyers gonna commit a look at them anyway so you want to make sure you understand them first it really gives the sell gives greater confidence in the seller when the buyer has that you know when a potential buyer investor comes in and you can hand them a koala a quality of earnings report upfront the buyer merely has more confidence and you understand your business you and you understand the issues and quite honestly we tell the seller is a little time if you know something is wrong you want to get that out there on the quality very important and put it out there you know things like you know you have you have a property thanks collecting and paint remaining sales taxes if you've got you know personal expenses running through the business you know any of those kinds of issues it's one of those things the buyers going to find out anyway when they dig into it so you so it's better if you just put it on the table up front I corporately address it and deal with it and it just really kind of makes the transaction go much more smoothly because you don't want it the last minute for the buyer to come in and say oh by the way we found the problem because they're gonna want to renegotiate the deal right and you want what you don't want that to happen to tell her and John that I think that's the million dollar question about all the things that all the content and insight that you've given us in the past couple slides it all goes back down to purchase price so if you if we're finding things that normalize if we're finding these things that you know impact valuation what kind of you know what can people expect when it you know with regards to adjustments and things of that nature so you know in my experience you know the seller at the end of material you know obviously obviously it can it could derail the deal I mean that does that does happen although it doesn't happen very often quite honestly what what the buyer will typically do is if there's a lot of adjustments negative type adjustments where the way the eave it is ends up being much lower than they expected you know they they may want to go she ate the price they may want to put some amount in escrow they may want to make some of it turn some of it into an urn out if they're not sure how the results are going to be none of the more typical kind of results you see as a result of a quality variance report where that where the buyer will the overall price may come down but more often than not I think you see that either either tell them some of the purchase price is held in escrow or some of it's converted to earn outs if the buyer had a little less confidence and what what did what the deal looks like those are kind of how most buyers I've seen react to it and that's why it's important from the sell side to kind of get those things on the table up front because you don't want those coming coming up to Lessman and quite honestly you then can address it now I have to say that most buyers when they're coming in they may expect some adjustments I mean they particularly if you've never been audited if you're looking to sell your business it's never been audited you were kind of in that startup mode you don't have a very sophisticated accounting department sophisticated CFO you know the buyers you can expect a certain amount of adjustment and that's okay that's a they generally don't get those don't go crazy about it um it's just you don't want to have any any really big negative surprises that that's what can derail a deal at the last minute got it got it okay that's good insight in terms of you know kind of what is it what is the QV process what does it look like you know we start with sort the management financial statements which tend to be much more detailed as I'm sure you're well aware you know your honor the financial teams tend to be fairly high level but underneath that doesn't typically the manager plan statements which or a lot have a lot more detail and that's where we start and we always start with manage when we basically determined management reported management determined EBIT das and then we work from there you would expect to get a you know we would come in and give a a PVC list prepared by client list which is very similar to you've ever been audited you're very familiar with those it's a list of requested documentation that we want and it's it's you know it's kind of all the a lot of same kind of information he's gonna you can request for an audit account reconciliations things like that but it's going to be more much more operational focus have you've seen the things we're looking at it's heavily focused on customers customer concentrations where the customers are the lot more inventory detail a lot more into the trend analysis monthly or quarterly trends or the financial statements then you're going to see with an audit again because it's that much more much more operational focus often the timeline is very compressed particularly on a buyer because the buyers gonna committee they're gonna want to complete this process and in kind of four or five weeks typically at most so you're gonna be gonna be very compressed timeline so it's gonna be you know kind of kind of a lot of work and sometimes be a lot of hours and a fairly short amount of time to kind of pull this information together make sure you understand awesome okay another reason which is another reason by the way if you're thinking about telling you this now there's done a plug because you'll get a lot of that information ready so the buyer comes in you have that have that readily available if they want to go on and do their own Q of eight that sounds really good so would you say a Q of V is normally done then Don even it sounds like even if you have audited financial statements the Q of E is a good thing to do in in addition especially if you are a privately held company I mean you know closely held company I should say yeah yeah it's there almost always done um to some degree because I mean on it is just I mean I ought to provides a lot of good information no no get me wrong I know senior former auditor so you know a lot of great information uh it just does have enough detail really typically with the buyer really want some dish make sure they understand they want a much more much more detail by month or my quarter and as we've seen in things we've talked about a lot more detail around customers and level of expenses and trends things like that that just they aren't subject to the audit the artisan annual is typically an annual look at the numbers you know the numbers are right for the year but it doesn't kind of tell you what's going on in each of those 12 months great this is good inside John thank you so much well I think is one more slide yep yep yeah you know what should you do to do to prepare if you're looking to sell a business a lot of it's like the frame for an audit as I said you know make sure your account reconciliations are all up to date you understand your business you really want to focus on quarterly numbers if not monthly you know a lot a lot of small businesses Heather just kind of close the books once a year but you really want to kind of go back and try and clean up those quarterly numbers and make sure you got your at least your quarters clearly stated because that's what the quality reports going to look like we're going to look at and you get it's going to be a lot more painful process if you don't if you're doing it to do it at the last minute and the other thing is really understand your business you know it's a lot of the quality of any reports we come in and it becomes as we're trying to do this we want to make you want to make sure you understand as a seller of the business who your key customers are where the concentrations are what are the trends and variances in the business if you're doing a budget versus actual analysis if you're not doing a bunch of its actual analysis you probably want to start doing that because it really helps you understand the business because the buyer that's what they're going to want to know they're going to want to be able to dig in and really kind of understand all that information and you as this seller you want to make sure you really understand and have an information readily available so if you're thinking about selling the business you want to start now to really start understanding and tracking that information so ensure you're ready awesome and we're right they're at the end of it unfortunately John it's or right at the end of it we don't have time for questions so what we will do is thanks for everybody who left a question we will circle back with you we do hope to see everyone next month for the completeness of tax accruals we know that tax accruals are going to be a big P they are a big piece of an M&A activity currently and we're going to dive into that a little bit more next month we hope to see you guys tune in then and we'll follow up with everyone on their questions after this so thanks so much everyone okay thanks everyone