Touchstone Talks: Ep 6 - Show Me the Earnings! Why Q of E Matters

They had

said that.

It actually

is not every. Day.

That I.

Meet. Him.

Maybe it.

Means we.

May be.

Okay.

And he is.

Back.

And we.

May be.

In the.

Yeah.

And I and
I started in a more traditional role doing

auditing work.

Started with a firm called Bloom.

Shapiro. We.

I was with bloom for ten years before
we merged in the CLA and started doing

more traditional, like financial statement
audits for private businesses.

And when would somebody need an audit?

Typically
because they have some sort of bank debt.

So they have a requirement

where they have to provide
audited statements to their bank.

At the end of the year.

We do a lot of work for a lot of, like
municipalities in Connecticut as well.

So they have, you know,
they have their own kind of responsibility

to submit financial statements.

Same with a lot of
like the nonprofits and schools.

So I did some of that work.

It was a great foundation
and base for me to build up knowledge,

but it certainly wasn't
like a passion of mine.

And then I moved up to the Boston area.

Yeah, about 2 to 3 years into my career.

And when I got up there, started doing

some work with the search fund community
coming out of Harvard Business School,

their entrepreneurship program,

and as soon as I started doing that work
and helping

support them with their acquisitions,
I fell in love with the work.

So for anybody that doesn't know
what a search fund is, a search fund is

when you are looking or searching
for a business to buy yourself.

Yeah.
They're normally smaller businesses.

So some of our owners
may sell to search funders.

And they're essentially buying
the business to operate

from a starting point
that's a preexisting driving profit.

Yeah.

Yeah.

So these were, you know,
these were mostly people in their early

30s, right, who had had like
an initial career in Wall Street, right.

Then went back to Harvard
to get there, to get their masters,

to get their MBA, came out of Harvard's
entrepreneurship program

and like you said,
did a search to find an existing business

that had an owner that was looking at
transition where they could take it over,

own and operate it,
and continue to grow it.

And HBS at the time had a great model

where the two main, professors
who started that program,

what kind of pick their top students
every year and invest and support them.

And so we would work directly
with all their top students

and just do the actual quality of earnings
work, support them on the transaction.

Then afterwards, help them with the actual
accounting work for the business

so that they could report
to their investors.

So that's how I kind of got my foot
in the door doing this kind of M&A work.

I loved the kind of piece of it.

That it was something different
all the time.

It was exciting.

I didn't mind that.

It was like more pressure.

And,
not everybody does well with pressure.

No, there are certainly some people
on our team who, you know, was it wasn't

a good fit for, but I enjoyed

and still enjoy the fact
that it is like a new challenge every day,

and you're always being forced to learn
and expand your skills and adapt.

It felt like
I would have gotten very bored

and kind of stagnant if I had stayed.

Doing financial statement audits
for the same clients every single year.

Like, it just it didn't feel like
that would have been a a mental challenge

for me.

Way back when,
when I, when, before I found M&A,

I was told, oh,
you should go into the business world.

You'd be great in the business world.

And that was my worry that it was going
to be the same thing every day.

Yeah. And I was just going to be bored
out of my mind.

Yeah.

No, mergers
and acquisitions are not boring.

No. Certainly not.

Certainly not the same thing.

Every every month,
let alone every day, so.

Oh, shoot.
Every hour can be a different task.

Yeah.

So quality of earnings, we generally,

as a sell side advisor, say to certain

size businesses you should have this done
before we go to market.

You should know what it's going
to adjust out to.

Yeah.

And in preparation for that,
one of the things I did was

I went and took a course
on quality of earnings.

I left that course knowing as

much about quality of earnings as I did
when I walked into it.

So I didn't even know those courses
existed.

Yeah.

I wouldn't recommend that particular one.

Yeah. But,

tell our our owners that are listening

kind of what is a quality of earnings?

Better than that class did, please. Yeah.

I mean, ultimately, a quality of earnings
is meant to be an exercise

to really verify the accuracy of their of,
you know, of your financials.

Understand,
like the cash flow and earnings of

the business is really generating.

And more, more important
than anything else like

we always say normalize those earnings.

To ultimately show like what would the
business look like on a go forward basis.

What do you mean when you say normalize?

I feel like that's maybe the largest
hang up that our owners run into.

Yeah.

So, you know,
when when when I talk to business owners,

I try to, draw the distinction of,
you know, they're operating the business

as, you know, as a sole owner,
it's a private business.

So there are certain things
that they may be doing that if a

if someone else came in and bought
the business, they may not do any more.

Right.

Things like they may be paying themselves
or family members a certain wage.

You know, again, because it's, you know,
their business there a lot of times

they're running their business
to manage their taxable income.

Right. They're trying to limit the taxes
they pay.

That doesn't mean
that it's actually reflective

of how much profit
the business really makes.

So when you're trying to present
to somebody

who's interested in buying the business,
we say normalize.

We want to show what the actual cash
flow and earnings

are that the business is making,
not what the net income

is on a tax basis, because those can be
two very different things.

Definitely, definitely.

And what, when you're normalizing,
one of the things

that I see as a challenge is

many, many businesses,

despite XYZ run on a cash basis

and a buyer
or even a banking or lending institution

is going to anticipate
seeing things on an accrual.

Yeah.

So tell us real quick
what am I talking about?

What's the difference? Yeah, yeah.

And like you said, most business owners

because they're really running their
their business

based on what they're going to pay for
taxes,

are really focused
on the cash flow of the business.

Meaning
when am I getting paid by my customers,

when am I paying my vendors, and how much
cash do I have in the bank account?

Can I pick payroll today? Right?

That is very different
than what you have actually

earned for revenue,
based on the services or goods you've sold

and what you actually owe as liabilities
to your vendors or to your employees.

So when we talk about doing that cash
to accrual conversion, it's understanding,

you know, is your business growing,
but you haven't collected all the cash yet

because you have outstanding receivables

from your customers,
which most companies do. Correct.

And are there certain liabilities
that you haven't paid for

but you technically oh,
you know, you've gotten invoices

from your vendors
or you owe your employees a bonus, right?

Or, you know, profit
sharing at the end of the year,

but you're not going to pay until March
15th when it's due for tax purposes.

So again, it's part of that exercise
to present the financials

in a way that a lender or an investor
would expect to see them

consistent with kind of general,
generally accepted accounting principles.

And we hear the word GAAP all the time,
which is generally accepted

accounting principles.

And I've even heard a CPA say,

oh yes, my client's
financials are on GAAP.

And then I look at them
and I go, no, they're not. Yeah.

The term can be used very loosely.

Right.

So and
and when you're preparing your taxes even,

even if you're getting a prepared
financial report from your CPA

with your tax prep,
nobody is checking that you're on GAAP.

There's no like,

you know, red
pen happening on these things.

Yeah.

Because the government
just cares to pay your taxes.

Yeah.

And certainly right now with the with

the amount of people that the IRS has,
I think they have a bigger, bigger issue.

Absolutely. Absolutely.

So, you know, operationally,
you can be just fine.

And we see many owners,
bank a set amount of cash, right?

So they never have to worry about
am I going to pay payroll on my end?

And I was working with one client, and,
they said, oh, we,

we were talking about accruing,
the investment

and why, you know, you generally
spread it out over the months.

Yeah. And, it was a substantial amount

that they just deposit into the,
the 401 K plan.

And I said, so
how have you made that payment every year?

And, the CFO goes,
I just wrote the check.

Yeah.

And I was like, well,
it's good that you always have the money.

Yeah. And he goes,
I never thought about that. Yeah.

And I was like, oh, okay.

So it's those kind of differentiations

that, are just not how

you operate your business
on a daily basis.

And, I, I say this all the time
because then we'll pivot to,

to working capital here for a hot second
because that's a,

that's another,
another point of education.

You never

an any point of operating your business

need to stop ownership on one certain day.

Yeah.

And have it the somebody new on it
the next day.

Right. That's not an operating feature.

That's generally in place
until you go to exit.

Yep. And, you know,
whether you're doing an internal transfer

or an outright sale,
bringing in a partner, escaping

any of those, you're going
to have to draw a line in the sand, which,

if anybody's been to the beach, it's
not easy to do.

Yeah.

So there's a structure that we, you know,
we refer to regularly,

which is not working capital. Yeah.

So talk for a minute
about what that looks like.

Yeah.
And to your point, that something that

when you bring

that up to a business owner who's
never been through a transaction before,

they usually look at me
like I have four heads.

Because that's not a concept that they
think about in running their business.

But the, the intent behind
it is to understand

what the actual capital needs
are of the business.

So it's really in short,
it's really understanding

what the cash cycle looks like
for the business.

Right.

How quickly are they typically collecting
their receivables from customers?

How versus
how quickly are they paying their vendor.

So it's just it's understanding
how much again how much capital

there needs to be.

So that

if we're talking about a manufacturing
company that's making widgets, it's

from the time that they order
their materials and have inventory.

What does the cycle look like for them
to actually sell

and convert that inventory into revenue,
and then convert that into cash versus

the time cycle of when they placed
an order with their supplier

and have to pay for those materials.

Because ultimately
any buyer is going to be looking at that

and going to want to understand,
you know, is this a company that

to your point earlier,
you know, that CFO that always has enough,

you know, cash and capital

that they're not going to be worried
about paying payroll,

they're not going to be worried
about funding, you know, profit sharing.

Or is this a company
that has such a tight cash cycle

that we're going to have to use debt
in the line of credit to fund operations?

Sometimes that that makes
a really big difference in how a buyer

looks at a business, because it's
what kind of bring to the table.

Right?

Because it
it impacts their leverage on the deal.

So it makes a huge difference on how
they model it out and kind of assess

the value.

Yeah, absolutely.

It's it's a sticking point.

And every and there's, there's only a
thousand different ways to calculate that.

And that makes it a little harder.

Yeah.

It's something
that is absolutely not black and white.

Everything about it.

There are a lot of gray areas, a lot.

So it is definitely,
as you know, one of the areas that ends up

getting negotiated
have I see them heavily.

Right.

When you, you know,
whether upfront in the alloy or certainly

once you're working towards
a purchase agreement at the end.

Because there is no yeah,
there is no just strict formula

that you follow every time for working
capital.

No, no. Yeah.
Even though they say there is.

Yeah.

Every buyer says,
oh this is the way it's always done. Yeah.

And every one of them I'm like,

you know, I've never seen it done
the same way twice or. Yeah, exactly.

It's it's always a little bit different.

Well it makes sense.

Like all of these things
being specific to a business makes sense

because every business was formed
and operated differently.

Yeah.

Because to person a different

task a different
and a, you know, a business that's been in

operating for 100 years is going to have
a different set of processes.

Yeah. Yeah.

I mean, fundamentally,
you know, one of the simplest analogies

I usually make for people
where I'm trying to explain, like what

we're trying to accomplish
with our quality of earnings, again,

because most people,
even if they haven't sold a business,

have bought or sold a house, is, you know,
if you're trying to sell your house,

you wouldn't just show people pictures of
the house and be like, okay, here you go.

Here's what it looks like.

Although some people do that now and say,
I buy it as is,

most buyers are going to come in and hire
a professional to do an inspection.

Correct. Right. That's
what a buyer is going to do.

They're going to do a quality of earnings
to actually inspect your financials

and make sure that everything you've told
them makes sense.

They want to see that

all the light switches work
and the plumbing isn't leaking.

Right.

So like you said,

we do this a lot more on the sell side
in advance now to get ahead of that.

So there are no surprises
when a buyer comes to the table.

And hopefully we can identify

those little things that need to be fixed
or tweaked to say,

okay, yeah, we're going to
we're going to put some new paint on this.

Right. Right.

We're going to we're going to fix that,
that light switch.

And now it's,
you know, it's not something you're going

to negotiate with a buyer about.

You'll be able to get top value
for your business because of it.

Right.

Well, and,
having a third party come in like clay

and do the quality of earnings versus
we look at stuff internally

and try to, to kind of fix the,
the light switches ahead of time.

So there's a,

a level of business that we refer to.

So people like you to do this.

What's the magic number

on when a size of a business

should consider a quality of earnings
report?

Yeah.

I mean, I think, you know, as a firm,
we we do a pretty good job of,

I'd say, applying a flexible approach
to it where we can scale up

and down our work to be practical
for what's needed.

Now, with that, I'd say, you know,
we're typically working with businesses

that are, you know, on the low end,
maybe 1 to 2 million of EBITDA.

And then on the higher end,

you know, anywhere from 10 to 20
plus million of EBITDA.

So certainly if you're a business
that's doing 10 million plus of EBITDA,

you're going to want

a quality of earnings done, even if you're
working with an outside CPA.

But where we spend most of the time,
honestly, is in that like 1

to $5 million EBITDA range
because most of those businesses

don't have like reviewed
financial statements.

They don't have a CFO, right?

A lot of them have a controller
or a bookkeeper.

They're using QuickBooks,
their cash basis.

So that's where we can provide
the most value.

And what revenue does that translate to?

Understanding that many of our owners
may not know what their EBITDA is.

Yeah, I'd say, you know, it's
anywhere from, you know, probably

like 5 to 30

million of revenue is honestly
where we spend most of our time.

That's even 5 to 50 million
above that size.

We still do a lot a lot of quality
of earnings on the sell side.

But usually those businesses
are more sophisticated

and have more controls
and have a more robust finance team.

So it's still valuable for us to come in
as an independent third party.

But it's more of a

check the box exercise as an outside
third party to validate what management

has already done, as opposed to
when we work with smaller businesses,

just like, you know,
like we're we're holding their hands.

Absolutely. It's a lot of education,
right?

It's a lot of doing the work and then also
teaching, educating along the way.

Right. Agreed, agreed.

So we see a process called rolling
forward.

Yeah.

Often, and I just want a real quick
talk about why that would happen.

Just like every other point of finance,
it's you look at from here to here.

Yeah. And then you stop. Yeah.

But the company doesn't stop
the operations don't stop.

And the deal process doesn't stop. Yeah.

And so what happens
when you roll something forward?

Yeah.

And especially in the current environment,

I mean, our, our experience of late is
that deals are taking longer to get done.

So, you know, when we do our initial

quarter of earnings, like you said it's up
through a certain point in time.

And then when we're rolling forward,
it's exactly that.

We're updating it

and kind of refreshing the analysis
and the numbers to be more current

with the actual operations
of the business, because any buyer

is going to want to know. It's great.

It's great that you presented this
historical analysis

of what the company did see
through the end of last year.

We want to know what it's done
so far this year

to make sure that you're still on track.

Yeah.

That you're, you know,

looks like you're going to hit your budget
or your forecast for this year

because the last thing
a buyer wants to see is that

the business has started to trend
in the wrong direction, or tail off,

because the owners might be taking
their eye off the ball as they

deal,
or macroeconomics have been a problem.

Right? With right.

With everything going on right now.

Right.

The potential impact of tariffs
like any buyer's going

to want as much information as possible.

So that role for is our way of
just trying to improve transparency

and just give them,
you know, up to date information.

So we prep our owners in advance
to understand that

no part of diligence is easy, and that
they're going to need a lot of things.

Quality of earnings

are notoriously difficult.

What is an owner going to need

to provide you to be able to do your work?

Yeah, it's it's a lot of data.

I'd say, you know,
when we work with businesses,

you know, in our part of the market,
we try to make it

as least painful as possible.

So a lot of times, because they're using
a basic system like QuickBooks,

you know, we'll work with them to just get
a backup of their QuickBooks file

so we can get direct access to their data
where they don't have to be in the weeds

playing courts for us, because we do need
to get into like detailed transactions.

You know, we're going to be looking at
bank statements and understanding,

you know, especially for doing that cash
to accrual type of analysis understanding,

you know, what they've actually collected
versus what they've billed out.

So it's a lot of getting that raw data.

And usually
if we can get access to their system,

it makes their lives a lot easier.

And then we can spend our time,

you know, having discussions with them
to make sure we understand

the business, that we know it
inside and out, just like they do.

So that ultimately, when they start
to have conversations with the buyer,

you know, I think a big part of the value
that we provide is not just doing

that analysis and then disappearing,
you know, and walking away.

It's staying and riding along with them
throughout the process.

So that we can act as a buffer
and answer a lot of questions

that come up from a buyer's team
so that it's less, you know,

less weight on their shoulders
having to deal with that process.

So and that brings up
kind of where I was going next actually.

So perfect segue. Thank you.

We see we

we asked certain people
to do sell side of these regardless

if there's not a sell side of done
or the buyer is going to do.

Yeah. Do one. So

the, having you
along the way and the support is fabulous.

We actually had one
we're working on together where you spoke

with the buyer's CFO, and they opted
to not do their own quality of earnings.

They said, oh, we we trust Jason.

We trust Clay. He understood it.

You know, and that saved time and energy.

I think when you're doing a buy side show,

it's a lot harder to be like,
here, Mister firm that I didn't hire.

Here's access to my QuickBooks.

Yeah, that's a scarier position
to put yourself in.

It is for sure.

You're right, because you don't have
a relationship with that firm whatsoever.

You know, if, if you're,

you know, if you're hiring, whether you're
hiring Clay or a different firm, right?

They have a fiduciary duty
to, you know, they're working for you.

So there's certainly different kinds
of confidentiality and things like that

that make it, I think, more comfortable
for a business owner.

But yes, if you

haven't done any of that work up front,

then you're going to
I mean, the level of detail

that the buyer is going to go into
is at a completely different level

than if you've shown them
that you've made the investment

to do a lot of work ahead of time,
to spend the time and money to do it.

Then they know that you're really serious
about the process.

So makes a difference.

Well, and we see owners hesitant
to spend the money because it's not free.

Yep. You say you
it's it's a commitment to do it.

Time and time and money.

And they're like,

oh, we'll wait and we'll do it
when we have a buyer.

It's going to expand your time. Yeah.

So how long does this process take?

And I know that's a loaded question.

And you're always tired of me asking you,

you know.

And you're right that it
it obviously depends.

But I say in general, we are usually able
to get through our work

in like 3 or 4 weeks.

If it stretches longer than that, it's
usually because either we're having to do

more work than we expected on
that kind of cash flow accrual conversion,

or there's just delays

in getting the information, and then maybe
it can take up to 4 to 6 weeks.

But that's usually the timeline
that we work under.

To your point, Deb, like doing that up
front can really help with the timeline.

Once you signed the letter of intent.

Especially if because you know this

when you're getting offers
from from different potential buyers,

a lot of what goes into consideration
is like, what's the certainty to close?

Well, if you know that they already

have the capital secured
and they can kind of run a quick process

and you've done a sell secured in advance,
so you know that that's not going to be,

you know, a long
pull in the tent for them.

That's a big difference versus
somebody who has to go out

and find the funding
or deal with a lender.

And by the way, says, yeah,
our team is going to need six weeks

to do their financial
and tax cuvee on the target.

Well, and we don't have,

a situation always where you have the

you can't go
get the financing without the QV.

So you're not going to start
like these are not commingled processes.

You have to finish the Q of your before
the bank will accept the numbers.

Right.

Then you have to start
writing your contract.

Right.

After that,
because things could fall apart.

And that's a, the more time in a process
from when we have an agreed

upon purchase price and structure
and all the the details in the Loi,

the more time there are for things
to change.

Markets to crash. Tariffs to be employed.

Like anything
can happen in that amount of time.

So the shorter
we can keep that time the better.

Which is which is why Jason knows.

I'm always like, how soon can I get that?
How soon can I get that?

Can I get that now?
Yeah, you get that to me tonight.

Well, I mean, I think every professional
in the in the deals space says, right.

You know, time kills or deals.

It's it's not your best friend. No.

You have more time.

You want, you know, you want,
as much as it can be stressful

having a compressed timeline
and having to kind of sprint

if if you have that
and can keep things on track.

I get it increases the likelihood of this
of a successful close,

which is what we're all trying to like.

Absolutely. That's the
that is absolutely the goal. Yeah.

So as we wrap up here,
it sounds like you had,

an interesting journey into this career.

So if you were not doing this,

what would you be doing?

So, interestingly enough,

the only time that I considered
pivoting a little bit

and I, again, still would have been
in accounting, but, I got my CFP.

I was very interested
in going into forensic accounting

and applied for a job with the FBI
in Washington, DC.

At the time, my wife was applying

to PhD programs,
and she applied to Yale and Johns Hopkins.

She got accepted to both.

So while we were deciding where we were
going to go, ultimately moved from back

from Boston to Connecticut,
which is what we did or moved to DC.

I applied for a job with the FBI,
got an interview,

and then we decided
she decided to go to Yale.

So if I was going to have pivoted,

I was going to go down a road of
being a forensic accountant.

Which at the time I joked with my wife,
I was like,

I'm going to be an accountant with a gun.

How terrifying is that?

Yeah.

I didn't even know that
they let them all have guns.

Well, and in hindsight,
it probably worked out for the best

because there's no way I would have
made it through the physical training.

Like I would, because I would have had to
go, like, actually to Quantico.

And oh, and did her physical training

in order to be an EV,
even though I wouldn't be an actual agent.

Right. Like I was,
and I would not have survived that.

So it's probably for the best.

That's some self-awareness.

That's good. That's good. Interesting.
Yeah.

That sounds like a lot of fun, though.
Yeah. So safer for everybody.

I don't I don't carry a gun.

I didn't have to go do weeks of physical

They had

said that.

It actually

is not every. Day.

That I.

Meet. Him.

Maybe it.

Means we.