Punching Out! What Is a Quality of Earnings Report?

For the past several years, quality of earnings reports (also called “Q of E” reports), have become more popular in M&A deals. Whether the seller’s financials are audited, reviewed, compiled, in QuickBooks, or on the back of a napkin, a Q of E report helps buyers become more comfortable with the seller’s numbers and identifies risks in the business. Until recently, these reports were mostly completed for larger deals, but lately, they have been performed for companies at $10 million in revenue or below. The reports are for a specific M&A deal, performed by a third-party accounting firm, and usually take a few weeks (2–4 during the off-season, and 4–8 during tax season) to complete.

Q of E reports are almost standard for all public and private-equity buyers for deals above a certain size. This is to provide a third-party analysis and review of the seller’s financials and the structure of the deal. Third parties are independent and have no stake in the game, so they are generally unbiased and not influenced by any pressure to do a deal. Public company boards of directors and private equity investors typically insist on getting these reports, not only for their independent analysis but also to provide another perspective on the deal that the buyers may have missed (in other words, “CYA”).

The Q of E provides analysis into the quality of earnings—that is, how sustainable are revenues and earnings and how realistic are the seller’s projections. Depending on the scope of the report and the buyer’s concerns, the Q of E team can look into a wide range of topics. For example, if the seller’s customers are mostly well-financed blue-chip companies, revenues are based on long-term contracts or repeating programs, and revenues have climbed steadily, those earnings would be generally high-quality. However, if customers are mostly smaller companies, orders are lumpy or spotty, there are a lot of one-time orders, suppliers are small and overseas, the equipment was purchased in the ‘80s, and revenues have been up and down, the Q of E team would probably rank those earnings as lower quality.

The Q of E report also looks at the quality of assets, various accounting policies, the quality of the supply chain, financial controls, the level of the management team/financial reporting, IT systems, and a wide variety of other factors. The scope of the report depends on the concerns of the buyer and the complexity of the business. The costs also depend on those factors and can range from around $25K for a limited report to up to $100K for a complex report for businesses in the $10–100-million range.

In recent years, sellers have become more proactive and have requested Q of E reports on themselves. This is a bit like getting a home inspection completed before selling a house or getting the mechanic to check out your car before you sell it online. Getting a sell-side Q of E report gives buyers confidence early on, uncovers issues, makes the process quicker, and is a strong signal that the seller is serious (and wants a serious value for the company). Sell-side Q of E reports are becoming standard, so not having it puts the company behind other sellers.

If something negative comes up, you can hit the “pause” button and fix it before going to market, or at least disclose it in advance and avoid any surprises. Sellers who are thinking of going to market in a few years could get a report done now and have plenty of time to correct any issues. A refresh of the report when the company is ready to go to market should be easier and less expensive than the original report.

As an owner or executive of a company, you have worked there for years, so you understand the business well and have accepted all (or at least most) of the risks of the business and industry. Owners can get blinded by familiarity, and they all think their babies are beautiful. Buyers may come from a slightly different part of the industry and may organize their business differently. Private equity, or other investors, may not know the industry well. A Q of E report can give the owners and executives a perspective of the business that they otherwise would not receive.

Who pays for the Q of E report? If it is a sell-side Q of E report, the seller pays, but it typically pays off in higher valuations and a smoother deal. If the buyer asks for it, the buyer typically pays. However, some buyers may say that the seller has avoided paying audit fees for years, so the seller should at least pay half. For companies under $10 million in value with relatively simple organizations, a Q of E report may be overkill, but it is recommended for larger companies with more complex organizations. If the buyer requests the Q of E, it is almost always after a letter of intent is signed, and the parties have entered into an exclusive due diligence period.

The main differences between a financial audit or review and a Q of E report are that audits check to see if the financials conform to GAAP, and they are backward-looking. Q of E reports take into account add-backs and a variety of risks, and also cover forward-looking projections.

A great Q of E report can help support a higher valuation, better terms (more cash at closing, less earnout), a smoother negotiation and due diligence process, and better reps and warranties terms (or lower reps and warranties insurance premiums). It can help the buyer with their financing efforts and help them get approval from their board of directors or investment committee. A Q of E report does not replace buyers’ due diligence, but it can be a very important independent tool for understanding the business.

Tom Kastner is the president of GP Ventures, an M&A advisory services firm focused on the tech and electronics industries. He is a registered representative of StillPoint Capital, LLC—a Tampa, Florida member of FINRA and SIPC—and securities transactions are conducted through it. StillPoint Capital is not affiliated with GP Ventures.

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2020

Punching Out! What Is a Quality of Earnings Report?

03-23-2020

For the past several years, quality of earnings reports (also called “Q of E” reports), have become more popular in M&A deals. Whether the seller’s financials are audited, reviewed, compiled, in QuickBooks, or on the back of a napkin, a Q of E report helps buyers become more comfortable with the seller’s numbers and identifies risks in the business. Tom Kastner explains.

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Punching Out! Down to 199

02-25-2020

According to the database at Tom Kastner's firm, the number of PCB companies in North America is now down to 199. This is a psychologically significant number for the industry. Tom unpacks this number, provides insights on trends, and shares his firm's predictions for the future.

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Punching Out! Preparing for Life Post-transaction

01-20-2020

Congratulations! You have punched out! Now what? Tom Kastner details how being prepared for life after a transaction is a good idea not only to help set up a smooth sale but also to give you the motivation to get through the deal process.

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2019

Punching Out! Why Buy a PCB/PCBA Shop?

12-31-2019

Overall, the U.S. economy is strong, and manufacturing has seen a resurgence over the past decade. Still, the overall trend for investors and small company buyers for 20 years has been in asset-light, tech-enabled services businesses, such as Uber, Amazon, Airbnb, etc. Given that background, why should someone buy or invest in a North American manufacturing business such as a PCB or PCBA company? Tom Kastner explains.

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Punching Out! Lessons From Recent PCB/PCBA Buyers

11-25-2019

Tom Kastner reached out to several buy-side clients as well as others who have recently made acquisitions in the PCB and PCBA sectors. He shares some common themes and their thoughts on what went right, what went wrong, and what they would do differently next time.

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Punching Out! Trust Is a Major Factor in M&A Transactions

11-04-2019

Trust is critical in M&A transactions. Both parties are naturally suspicious of each other, and tensions run high even in the smoothest of deals, so any small molehill can be magnified into Mt. Everest. To avoid bigger problems, Tom Kastner emphasizes the importance of establishing trust from the beginning and continuing to be trustworthy throughout the process.

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Punching Out! SMTAI 2019

10-10-2019

My firm goes to a lot of trade shows—at least one each month—because it is a great way to meet business owners as well as their trusted advisors. Trade shows are also an excellent way to hear industry information that otherwise we would not hear (aka rumors).

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Punching Out! What Goes Into the Confidential Memo?

09-23-2019

One of the key materials used in the business sale process is the confidential memo or book, which is essential if an owner is considering a sale of the business. Even if you are considering a sale in the future, it is good to have a basic book ready in case an unsolicited buyer comes calling.

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Punching Out! Mid-2019 M&A Round-up

08-22-2019

There have been quite a few deals in North America in the PCB and EMS spaces over the past 12 months. I have attempted to track down a fair number of these deals and list them, but many are not publicized. What’s remarkable is that so many of these deals involve private equity. PE firms are certainly a great source of liquidity for owners in these sectors. PE-owned firms tend to make a lot of add-on acquisitions, so we’ll look at these companies to acquire many smaller shops in the coming years. Here are some of the most notable PCB, PCBA, and EMS deals since December 2018.

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Punching Out! Why Can’t You Sell Your Business on eBay?

07-25-2019

Wouldn’t it be a lot easier if we could buy and sell companies online? Owners could avoid a lot of trouble and fees as well as get deals done quicker. Unfortunately, it’s not that easy. Here are seven reasons why a business cannot be sold online and how owners can make the sale process go more smoothly.

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Punching Out! Exit Planning 101

06-26-2019

Proper planning can take away many headaches for the seller and buyer as well as increase the value of the company, help obtain better terms, and overall, make it easier to complete a transaction.

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Punching Out! Delegate and You Shall Be Set Free

05-29-2019

It is good for owners/CEOs to step back a few times a year and think about what they do well, what they like to do, and what others can do better. Delegating simple tasks, like sweeping floors, is easy, but delegating sales management or quality control might be tougher. Although delegating is difficult, almost no business can grow solely on the efforts of the owner.

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Punching Out! What’s Special About Your Business?

04-29-2019

To help sell your business to buyers, or to sell your products and services to customers, it is a good idea to find out what is special about your business. It is also important to know how to communicate what's special. Read on to find out how you really compare to the competition, and what concrete metrics and KPIs you can use to judge your own performance.

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2018

Punching Out! Avoid Surprises During the M&A Process

11-27-2018

No one likes surprises, especially in merger and acquisitions (M&A) deals; there are enough unknown variables to start with. As the deal progresses, tensions start to rise, so any additional variables can cause a disproportionate response. Below are some ways to avoid surprises, and how to deal with them when they come up.

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Punching Out! How to Avoid Key-Person Risk

09-06-2018

PCB West 2018 is next week in Santa Clara, California (September 11–13). Can you go to the show and visit a winery or two without your shop falling apart? Have you taken a vacation in the past few years? Can you afford to not do board rework on a holiday weekend, like this past Labor Day? If you answered “no” to any of these questions, you may have key-person risk.

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Punching Out! Beware of Customer Concentration Risk

08-08-2018

One of the biggest risks in M&A is customer concentration risk. It is hard to avoid as a business owner; if a customer is giving you orders, you generally take them! The next thing you know, your customer has 90% of your sales and they own you. We see this a lot in both the PCB and contract manufacturing industries.

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Punching Out! Dealing with Family Businesses

06-28-2018

Some families may have spent this past Father’s Day discussing family business issues, including when, how or whether to pass the baton. There are several issues to consider when dealing with a family business.

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Fact or Myth: Do 80% of M&A Deals Fail?

05-09-2018

We are often asked by business owners if the commonly quoted figure is true that 80% of mergers fail to meet expectations after closing. There is a fair amount of research on large ($1 billion+), public deals that suggests that the 80% post-closing failure rate may be true.

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How to Prepare for a Smooth Post-M&A Deal Transition

04-05-2018

Selling a company is an exciting process, as well as time-consuming, stressful, and complex. Both sellers and buyers are sometimes so caught up in the deal that they forget to properly plan the post-deal integration.

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Cross Border Deals: What to Look for and How to Manage

02-22-2018

My firm has been approached by foreign firms several times this year and in 2017 who want to acquire PCB, PCBA, or other electronics companies in North America.

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Punching Out! Top 10 M&A Deal Killers

01-25-2018

I am often asked about some of the reasons why M&A deals die. Although this is a very painful subject, hopefully through sharing these reasons we can help some deals survive the M&A process. Here are my top 10 M&A deal killers (and some of the solutions).

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2017

Punching Out! Survey on State of the North American PCB M&A Market

12-29-2017

Recently, my firm surveyed about 20 PCB manufacturers in North America with an estimated greater than $10 million in revenue. Quite a few replied, and we have spoken with many others throughout the year, which gives us a good view on the state of the PCB market. If I did not contact your shop recently, it is because we already talked within the last 12 months.

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Punching Out!: PCB/PCBA M&A Top 10 FAQs

11-13-2017

We talk with owners a lot about the possible sale of their businesses. Here are the top 10 questions asked by PCB/PCBA shop owners about the process.

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Punching Out! Case Study—Lessons on a Deal

10-19-2017

This is a story of one of our clients, a U.S. contract manufacturer that sold a few years ago. To maintain confidentiality, the names have been changed and the details slightly modified.

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Punching Out! Making the Process Easy (M&A Process Engineering)

09-06-2017

In the M&A world, there are companies that make it easy (or at least easier) and those that make it difficult. By making the process easier, sellers should see better valuations and terms, and have a smoother deal process.

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Punching Out! Bridging the Valuation Gap Between Buyer and Seller

06-13-2017

PCB acquisitions in the U.S. are down so far in the first five months of 2017, with only two announced deals (HT Global Circuits’ acquisition of Pho-Tronics in April; American Standard Circuits’ acquisition of Camtech in May); and one anonymous deal that I am aware of that has not been announced. This compares with 11 announced deals in 2016. There are a variety of reasons for the decline, but one reason could certainly be the valuation gap between buyer and seller.

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Punching Out! How to Put a Wrench in the Rumor Mill During the Sale of a Company

05-23-2017

When selling a house, the owner’s agent puts a sign in the front yard, posts info on the Web, and invites buyers over for an open house. When selling a car, we put a sign on the windshield and take out an ad with our phone number on it. However, when selling a business, some owners do not even tell their spouses.

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Punching Out! Selling a Company—Seeing it as a Triumph, Not a Defeat

04-25-2017

Somehow, there is a still a stigma that selling a company is a negative for the owner. Many people think that there must be something wrong, otherwise, they would not be selling. In reality, exiting a business should be looked at as a triumph for the owner, not a defeat.

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Punching Out! 10 Ways to Increase the Value of Your PCB/PCBA Shop

03-22-2017

I have worked with a wide range of companies in the PCB, PCBA, and other tech and electronics sectors. Through the years, I have developed some ideas on how companies can improve their valuation. Some of these ideas are simple and involve little cost, other ideas are more long-term and involve more effort or investment.

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Punching Out! When Should I Call an Investment Banker?

02-20-2017

The quick answer is ASAP. Even if you are not considering the sale of the company for 5−10 years, it is best to be educated and prepared. Give your advisor (or a few advisors) a call to discuss what can be done to get the company ready for a future sale. The worst time to call an i-banker or business broker is when you are forced to sell due to poor performance, health issues, pending bankruptcy, or dispute with a partner or manager.

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Punching Out! Types of Company Buyers in the PCB and EMS Sectors

01-09-2017

Mergers and acquisitions in the U.S. PCB sector have been in the news recently, with at least 12 deals completed over the past year, and several more in the works. In contrast, the EMS sector has been relatively quiet, but that may change now that the presidential election is over.

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2016

War Stories from the Front Lines of Deal-Making

09-16-2016

Here are some war stories from my experience in working on M&A deals in the PCB, EMS, and electronics fields. The names and details have been changed to protect the innocent.

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Timing: When is the Best Time to Sell?

08-18-2016

A few of the top questions we receive relate to the timing of the sale of a business. The first is, "Is now a good time?" The second one is, "How are market conditions?" These are the top FAQs.

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The PCB Sector—What Buyers Look for and Recent Deals

07-14-2016

The past few months have seen a rash of PCB deals in North America, for a variety of reasons.

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What the Heck is Adjusted EBITDA?

06-07-2016

If you are looking to sell or buy a business, you will most likely come across the term ‘adjusted EBITDA.’ Other common terms are adjusted cash flow, owner’s discretionary earnings, earnings after add-backs, etc. What do these terms mean, and why are they important?

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The Additive Process: Tips on How to Buy a Board Shop or Assembly House

05-14-2016

One of the quickest ways to grow a business is to acquire another business. At the same time, acquiring a business can be risky, and a really bad deal may put your original business in jeopardy. Here are some tips on how to make acquisitions.

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Your Baby’s Ugly, Now Get Over it (How to Work with Buyers)

04-14-2016

Here’s a scenario: An owner has gone to market and is starting to get feedback from buyers, and shockingly, not everyone appreciates the hard work and achievements that went into the business. Buyers may not understand the business, or they may be trying to position things for a low offer. In any case, it is important to know how to work with buyers.

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Putting Together the Deal Team

03-21-2016

When preparing to sell, remember the old saying, “He who represents himself has a fool for a client.” While many owners might be tempted to go it alone, in my experience it pays to have a deal team to help prepare a company (and the owner) for a sale

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Punching Out: How to Sell Your PCB/Assembly Shop

02-04-2016

You are thinking of selling your PCB or assembly shop. Perhaps you are contemplating retirement, you have no successors, and the thought of going to the office on Monday is driving you crazy. This column is designed to help your planning efforts. Future columns will go deeper into each subject

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