Two SMB Operators Interrogate the King of QoE on Why the Service is Needed
Do you really need a Quality of Earnings (QoE) on your SMB deal?
I recently got to talk through this question and many more issues related to the business acquisition market with two key members of the SMB community— Cole Simpson and Parker Cox. We got into the weeds about what trap doors are out there waiting for new buyers, how the market is changing, and why a QoE is your best bet to protect yourself and close a solid deal.
Cole and Parker asked me some excellent questions during our conversation that every SMB buyer should know the answers to. Through key moments from our conversation below, you will hopefully learn why a QoE might be right for you and what’s really at stake in your deal.
Key Takeaways:
Last year 40% of my QoE deals discovered fraud. That’s double from 2022.
The true value of a QoE is avoiding a terrible deal that could cost you millions.
Buyers blow up their deals trying to do diligence themselves instead of making an investment in their deal with a QoE.
What is a QoE? What’s the value of hiring someone like you?
A QoE is nothing more than a mini audit. There’s no requirement for private company financials to be audited and most owners run a bunch of personal expenses through their businesses. So, how do you as a buyer—who is buying on a multiple of SDE—get comfortable with the deal? It’s through the QoE process.
There are basically two levels of QoE. There’s “just good enough” and then there is a “normal/comprehensive” level (what would I deliver). The “normal/comprehensive” one - what I do - looks at all the historical financials. It builds up the P&L and the balance sheet from the bank statements, taxes, and essentially the aggregation of all the transactions that have been done. Now what I'll tell you—because I've seen my competitors’ stuff—a lot of them don't even reach the first bar. I've seen three pages of write-up, six pages of financials, and they call that a QOE.
That's you walking into a deal butt-naked.
That’s you paying someone $10k and them doing $5k of work and you’re happy until you’re BROKE.
If you do a QoE right, your QoE will be the “True” version of the CIM (that we all know is exaggerated). To accomplish this, you look at all the revenue, all the costs, all the items on the balance sheet, why are they there, what's in, what's out, what's sustainable, what's not, what trends. With that, you get a 30- to 45-page report that not only gives working capital and EBITDA, but all the trends in the business that you should be aware of before you buy it.
What do you actually need in order to accomplish a QoE? What's your turnaround time? What documents do you need?
Turnaround time for a QoE is four to six weeks, depending on when we get the data and if it’s a QoE where the numbers tell the same story as the confidential information memorandum.
Deals with a seller who is quick on questions will be done in four weeks. If we get caught on an issue, if there are delays in getting answers, then the process will take six weeks.
Our process is to send a due diligence list that's about 40 items long. My private equity list used to be five or six pages long, so we condensed the list to make it more palatable for small and medium businesses. Then essentially what I do is not just ask questions about the numbers, but ask questions about sales and marketing because we need to know the sustainability of the revenue.
In most of these businesses, you can fix issues with costs, but if you don't have a good hold on revenue, then you're stuck. A lot of buyers don't recognize how owner-centric, how algorithm-centric, how relationship-centric sales and marketing can be. Where we dig in more than others is into how the sales and marketing process keeps the cash flows high.
How many clean QoEs have you done? I just have to imagine the answer is close to zero.
Clean is relative. Clean is like there’s no fraud. When I say clean, I mean no issue that is over 30% or 40% of EBITDA or no issue that makes the deal hard to retrade. About half of my deals this year (2023) had some major issue. Half were clean and looked a lot like what's in the CIM plus or minus 10 to 15%.
How many deals have you run this year?
About 40.
Half of that means 20 deals were just “We're not even doing it.” And so of that other 20, what's the average percent trade that you're getting back?
When the QoE finds something that's 10 to 15% off, what ends up happening is my buyer, the client, negotiates something else in the deal besides a price retrade to get back that risk—either a longer transition period, more working capital, better reps and warranties in their purchase agreement, a bigger escrow. That's typically what people get. I think the value in that situation is knowing what’s going on in the business.
When there are deals that are off by more than 15%, that’s when there are retrades.
Of those 20 deals, what percent is off by more than 15%?
I would say probably half of that 20, so 10.
Okay. So out of 40 deals, half are just dead on arrival. And then half of that other half are going to be retraded because they're off by more than 15%. So 75% of deals in your experience—I know it's a small sample size—are just objectively different than what they are claiming.
Yes. Granted, I think people come to me for slightly tougher deals. I get a slightly more difficult data set, but I also dig a bit deeper to find stuff that other people wouldn't find.
Many times when you get into the deal more, do more diligence, you can find that EBITDA is off by 10 or 15%, but two or three other things might reduce your risk 10 or 15%. So, you’re still willing to pay the same price. Lenders are still happy to underwrite it.
Half the deals typically still get done. Half are DOA. And that's this year (2023). Last year (2022), only 20 percent of the deals were DOA.
As you look to grow and expand, are you thinking about diversifying your product offering? Like what's the next step?
I currently speak to a very specific audience. My typical client is an execution-oriented person who's sending LOIs and who's about a month or two away from getting a signed LOI. That was what was needed to build the business from the ground up initially.
What that meant is there are a lot of people in my audience that need my help who are earlier on in the process and aren't really execution-oriented. There's no service that I provide to help them. What I'm doing now is expanding my services to cover soup to nuts for folks who are doing self-funded searches.
We have a new first-time business buyers program. It's a monthly fee to get monthly help which all comes off your QoE— which is a way we can make it cost-neutral for people to get some help up front. We are about to launch a Deal Closer Society for part-time searchers who are staying on their job, but trying to execute with 10 to 20 hours a week. How do you compete with full-time searchers? Well, you can get with an advisor that can help you be more efficient.
There are also going to be some classes coming in 2024 along with a program called Guardian Grow which is going to help people who have closed the deal maximize their value as they grow the business, hopefully to sell to private equity and never have to work again.
Essentially I'm trying to help a broader swath of people who are in my audience. That's what I'm looking forward to doing in 2024.
From your experience, what is the most underserved segment of the market?
I think the first-time buyer or self-funded searcher is most underserved—which is 85 percent of my business. The reason is that for most businesses, they're not an attractive customer. They're not like a private equity group doing five or 10 deals a year. They're not an independent sponsor doing two or three deals a year. They may only do one in their life. So if your systems aren't set up to serve them, then you just look over them. My whole business is set up for that.
What is the value proposition of a QoE?
Again, a QoE is essentially a mini audit done on a private company by a buyer. It's a quick version of an audit to get you the cash flow.
What's the value proposition? Well, let me talk about what happens if you lose. The Acquiring Minds Podcast recently had an episode about a company that was about to go down. I am pretty sure that was a person that was in my funnel that considered doing a QoE with me, but decided not to and did diligence themselves.
They were a smart person who could understand financials—whatever the case may be.Still they missed 12 issues in the deal. (You can read a case study about that here.) 12 months after buying that company, they had to shut it down. By saving $25,000 on a QoE, that buyer lost a million or two.
That's like an 80X or 40X return on investment had they spent the $25,000 that I would have charged them to do a QoE. That’s the value.
If you don't get a QoE and think that the bank's going to save you or that you know enough, then you're basically taking a bet that nobody in the deal is lying to you. Unfortunately, when a seller is getting three to five times on each lie they tell you about EBITDA, even an honorable person has a huge incentive to lie.
When you don't get a QoE or you get a cut-rate one, essentially you're putting a million-dollar personal guarantee risk on the line because you didn’t want to spend $25,000 on a QoE.
Your QoE involves snuffing out the problems. You adjust earnings to reflect what's actually happening. What does that actually mean? How does your process work? What does that look like?
As an undergrad engineer and now a finance guy, I'm just relentless with numbers. We've amassed the best transaction accountants in the nation and the world.
It is so hard to get transaction accountants who will go the extra mile for folks because the data that we need to get and the analysis we need to do can just be complicated. When you need to spend three weeks trying to understand one piece of the financials in a company, most people would have given up or used one of the data sets that weren't accurate to put a number together and keep going. That's just not what we do.
We are just meticulous with numbers. We're also very friendly to sellers. We are very focused on letting our clients know the first time we think something stinks because we know that buyers are paying lawyers, taking trips, thinking about where they're going to put the kids in private school in this new city. So if something's wonky, I'm going to call you. But at the same time, what we're doing each week is sort of beating risk out of the deal.
We also prorate our fees over the four weeks that we're working so that if we find something wonky in week two— most of our deal breakers we find in week two—our clients are only paying half of our fees. I think that's part of why people appreciate our service so much.
Are there any trends you see in the key issues you guys identify that kill deals or at least lead to a retrade?
Sellers and brokers lying. It's really that simple. I could go down rabbit holes on the individual ways that happens. (Check out my War Stories here.) But at the end of the day, a seller decides that they're willing to lie to you to sell you a business that has no cash flow. And the broker won’t be savvy enough to know what is going on.
Do you find yourself primarily killing deals or is your QoE basis more about what the deal is worth? Is it like an evaluation play or a yes or no, like a binary execution?
At the end of the day, I work for my clients, so I can't tell them what to do.
My job is evaluating the financials and giving you both an EBITDA, which everyone does, but also a point of view on whether that EBITDA is sustainable. I can't predict the future. I'm not a magician. But after 15 years in this, I have some sense.
Once I deliver that to my client, they have to make a good decision. Now, if they're on the warpath to do a bad deal, out of my good heart, I'm going to, frankly, act up a little bit to make sure they understand the risk that they're taking on. But at the end of the day, I work for them.
Do you have any advice on buying a business or thoughts around how to interact with the seller?
What I would tell people is first off, recognize that a seller or a broker from a reputable place or that goes to church, loves his wife, will sell you a bogus deal in a second. Don't you forget it.
The second thing is kind of like picking stocks. You have to think about, whether you are the smart person in the room or the dumb person in the room. Are you buying crypto on the way up or on the way down?
The third thing I would say is a buyer has 10 or 12 hats to wear during the process. Talking to the seller, learning the industry, fundraising with the SBA, raising the equity, dealing with their family. And so when you add on financial due diligence to what you have to get done, you put pressure on those 90 or 120 days that you're trying to close. You really put yourself in a precarious situation.
The last thing I would say is that people oftentimes wait too long to start the QoE process. If you're not a transaction accountant, don't spend four weeks out of your twelve weeks looking at it yourself because you don't want to spend money. When success is owning a $3-4 million business, you have to play the game to win. Those are the pieces of advice I would give folks.
Everything you’re saying says hire me. This is so obvious to me. Why would you not hire this person? Why don't people hire QoE or you every time?
The whole self-funded search SMB concept is to be super cheap until after the LOI and after you kick the tires. But I would argue a point of view that asks, are you playing to win? If you're playing to win, then you have to spend to get the analysis done in the time to keep the seller happy to close the deal.
Once you start putting pressure on your deal—anybody in SMB world will tell you—these sellers don't think you have the money. They know the SBA is sponsoring 95% of your capital, so you’re not buying the company, the SBA is. They've been down this road before a lot of times. They don't trust some 30 or 40-year-old kid. Once you start putting pressure on deals, by the time 60 or 70 days hits, you're in a hot seat.
I think people don’t go for a QoE because they don’t want to spend their limited budget, they feel like they can do it themselves, and everybody said to be super cheap. Then at the last minute, people blow up their deals doing that.
Thanks to Cole and Parker for a great conversion! Keep an eye on my Twitter (@elliotteholland) for more discussions about SMB acquisitions and QoEs.
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