Mastering Business Valuation: The Power of Quality of Earnings

0:01Hey, everybody. Welcome to another episode of the Business Lunch Podcast with your host, myself, Roland Frazier, and the inimitable Ryan Dice. Can be imitated. Cannot. I've never seen anybody do it successfully. I've seen people try, but most of them, they were drunk. So, you know, I don't know. I had a way to get pretty close, actually. How the heck are you? I'm doing great. Got a new little one in the family. So that's an interesting adventure for my son, his first child. So you've been through this four times. this is actually first time I've had a grandkid for sure and so it's been interesting yeah first time really around like baby babies right no I've been around I've been around babies before you can't get to this age and not have people in your life having babies but yeah fair enough yeah but so now my question is are you going to change diapers like is this something that you're going to No, you're definitely not.

1:04No, I'm a big fan. I think it's the second evolution of our five evolutions is delegation, going from doing to delegating. So I like to hop in, you know, and mostly, you know, I would do it. But if I'm not practicing what we preach, then I don't feel like I'm in integrity with the program. Yeah, you're more of like a visionary grandparent. Yeah. Than like in the trenches. And by trenches, I mean, you know, it's actually it's kind of like you and I were talking about. I don't really get into operations, you know. I'm not really the, you know, that's, you know, like you and, you know, the father and those things, you know, that would be kind of an operational component.

1:44My thing is really more like, you know, kind of strategic, visionating, that sort of stuff, you know. Yeah. You should definitely change that kid's diaper. That smells terrible. That's more your style. Sounds awful. I'm sure people don't want to hear about that though No, I think we just talk about diapers and parenting and grandparenting the rest of this episode Let's hop into something that our audience might actually find interesting which you and I were having a kind of a cool discussion the other day I'll let you launch it and then we'll dive in Yeah, we were It was cool because I always learn something you know, anytime we talk I'm always learning from you Likewise you're you're you're very you're very smart and good looking and you know all the above mostly the latter so yeah mostly mostly the eye candy of the partnership but no that but yeah i mean the last time when we were talking we were i don't remember if we like brainstorming ways to uh increase company values and you know margin expansion and you just threw off this term you're like oh yeah you know q of e and i was like yeah and i've kind of nodded along like I knew what I was talking about.

2:53And I was like, okay, I know what that is. I've heard the term Q of E. I've heard of quality of earnings, but I'm not sure I actually know what it is or why it exists. And I learned a ton. And so I thought it'd be worth us just kind of talking through that because it wasn't a concept I was just incredibly familiar with. I've talked to a number of our clients. They weren't either. And yet out there in PE world, when it comes to valuing companies, this is a really important critical metric. There's an entire, you know, audits that happen around QV now. So I think just chatting about that, what the heck is it?

3:31Why does it matter? How do you optimize it? All of the above. Yeah, it's really interesting. So a lot of the acquisitions that we're doing our scale and exit consults for right now are, you know, finding that the QV, that quality of earnings report is really important. And they're expensive, by the way, to get. Like when you get a company, because there are companies that do those, you're talking somewhere between 100K and 300K to get that done. Now, obviously, if you're selling a million dollar business, you're not going to do that at that level. But when you get to higher level exits, even 10 million or so, the buyers are really concerned about risk.

4:16And as credit has tightened and gotten more expensive and companies have failed to realize their value that they thought they were going to get when they bought other companies, it's really become a trend to where Q of E reports are, you know, one of the key things that's going to come up. If you've got one, you'll definitely find that it helps you get more money because the pricing on your company, the valuation is going to be directly related to the amount of risk the buyer is going to take when they go. And a good QOV report will reduce that risk, which will allow you to command a higher price.

4:50So what is it? It's basically just how risky is what you've got coming in as revenue in terms of the ability for somebody that takes the company over after you to continue to receive that revenue and have it grow the way it has in the past. And so they're really going to be looking at several things. One, which we've talked about a whole lot, is recurring revenue, because revenue that doesn't have to be earned every single month or every single year, revenue that's on contracts that are annual or monthly, that's a risk reducer. So they're going to be looking at, you know, how much of the revenue in total is recurring, the more, the better.

5:33Then they're going to be like, OK, well, how sure are we that these people who are on recurring revenue programs are going to continue to pay us, you know, when the new bill comes? And that's really going to go to churn and retention and then net retained revenue. Also, like the quality of the customers, right? So, I mean, if a significant chunk of the revenue is coming from, let's say, your B2B and it's coming from larger enterprises, that's going to be more durable than if you're primarily selling just, you know, SMBs and startups and things like that. Yeah, I was going to get there. And not so much that client mix, but more like the credit worthiness that they've got.

6:16So, if they have good credit, and that can go to their performance with you. You know, are they paying on time? Are they paying late? all of those things. Because churn is like they're gone, but there's also accounts receivable cycles, right? So we'll look at that and say, you know, is our accounts receivable cycle, you know, good? Is our accounts receivable write-off rate good? What does net retained revenue look like? You know, those are all things that they're going to look at in addition to what's customer concentration. and they're even going to look at what is the prospect for the industries of the clients that you've got because if like they're facing major disruption like a lot of businesses are right now with AI then that you might get a ding for that.

7:04So those are all things that are gonna go into it and ultimately they're gonna put together this quality of earnings report and that's gonna go to the buyer and the buyer's gonna say, you know, okay, that sounds good or we're going to need to make some adjustments or more likely the structure of the deal is going to change from cash where you're getting cash and the risk is really on the buyer to something that has deferred components. It might be seller financing. It might be contingent value rights or CVRs are really becoming big. It might be earn out like all of those things. What's CVR? What's contingent value?

7:42around. CVR is basically a kind of a contractual version of an earn out. It's like, think of it as very often, it can be kind of anything, but it's more decoupled from the business to just a right that you get based on the occurrence of certain things as a contract, as opposed to it being directly related to the business's performance, like an earn out is. So it's kind of hard to explain the nuance, honestly, but it is more decoupled from the transaction itself. And it's better for you as a seller to have a CVR generally than to have an earn out because I think that it's in the 80 % plus range of earn outs that don't perform like the seller expected them to where they get that money.

8:32So a lot of those headline numbers that you hear about companies selling for, or it sold for 100 million, or it sold for 20 or 30 million, if there's an earn-out component, which there frequently is, then a lot of the times that's like, the actual proceeds to the seller are significantly less. The other component would be a roll-in, like the amount of reinvestment of whatever you're getting from the sale that the buyer wants you to put back into the company once it's done to kind of continue your investment. that has trended from a typical 20 % up to about 35 % these days. And so like, if you think about it, if you're going to get a big payday and 35 % of it has to be rolled into the new entities, which is indicative of how confident you are that the buyer is going to be able to make money.

9:24Now you're down to 65%. And let's say you take, you know, earnouts are ranging between 10 and 40%. let's say you get a 25 % earn out, you know, now you're at, you know, 60, 50, 40%, you know, and then maybe there's 20 % seller financing. You really only get 20 % of that headline price up front and everything else is later. That's definitely not as good. And so a weaker QOV could result in a structure that gets you significantly less of that headline price. And that's not even including holdbacks. Like there might be another 10 or 15 % three or four year hold back in escrow. Like the money's there, but you don't get it because the buyer is saying, you know, Hey, if we find things once we close the deal that we didn't expect, or some of the reps and warranties that, you know, that you've said were going to happen, didn't happen.

10:15Then we need to have something to, to go after. And then you're going to argue that they should buy reps and warranties insurance, but that is something that costs money too. So like all of those things are eating away at this, you know, this amount that you thought you were going to get and you kind of get into this fatal subtraction where you don't really get what you thought and you might not even get enough to be able to replace your income that you were making from it if you've got a really profitable business. So that's like that's really all kind of what goes into that and why it's important.

10:45Yeah. And the reason it's so cool is because when and why I think this is something we're talking about is most people when they think about selling a business, they think about, even a multiples, right? I mean, that's, I'm going to sell my business. My business has a certain, you know, earnings before interest, taxes, depreciation, blah, blah, blah. That's our profit. And then I'm going to earn a multiple off of that. Well, a couple of things with that. I mean, that's, that's true, but also oversimplistic because the, so you're going to have a multiple true-ish. Anybody who's done a deal knows, no, what you're going to have is a multiple range.

11:20And that range could be a three to six. It could be a six to nine, a nine to 12. It could be, you know, all across the board. And we hear probably most common with, with, you know, larger companies, uh, like 10, 10 million in EBITDA and even really five or six, if they're professionalized, like it, that, that there's operational quality also that I know we're going to talk about, but like that it's not just is the earnings good, but how stable are the operations and how able will they be, you know, to re realize scale and everything. So that's going to fit into that too. But companies with good operating systems and good QAV, I'm seeing most of the offers start in the six to eight, eight and a half range.

12:03But we can very often with good QAV and good quality of operations, we're, you know, very often pushing to double digits, you know, in the 10, 12, even 15. And that's the point. Like, I think that's the big thing I want to double click on because it's not just that you can get, a higher multiple range. Also within that multiple range, you can be on the higher end of the range. And also once you finally agree on where the multiple is going to be within the range, you can get a better deal to get more of the money that is multiplied by that. So it's one of these things where if you think about the difference between having really strong QV, it truly could be the difference between instead of being a six with massive earnouts, lots of holdbacks you know all these things with you getting 35 to 40 percent of the of the headline price yeah of the headline exactly versus let's say a 10 maybe it's not all the way up to let's say it's a 10 um and you know now now you're getting 60 percent 70 percent of it there it's not just that you doubled it's that you double doubled i mean you're talking about a difference between maybe you're taking home, you know, half a million bucks versus taking home, you know, four, you know, five, like, on the transaction on a small deal.

13:28Now, we're talking about, like, a big deal. Yeah. It can be$100 million plus, right? Right. It's significant. So you mentioned, in terms of QV, you mentioned recurring revenue is a good way to impact it. How do we get more of our, the revenue that's coming in to just happen automatically? um quality um i heard customer quality was in in there as well i know customer diversity is also a thing so you're not necessarily limited uh the credit worthiness which that made me think i remember the very first time i wanted to rent office space um they wouldn't rent to me uh and they said because you're not a class like credit kind of thing and i was super pissed i'm like but I'll pay like a promise.

14:13They're like, we believe you, but we want to be able to sell our property to someone else. And they're going to look at who our tenants are and ascertain their credit worthiness. And you don't have credit because you're a brand new business. And so they literally would not rent the office space because they knew that I would bring down the value of their property when they sold. And that's what you're talking about here coming into traditional business. So what other factors can impact QV? So channel diversity, if you're counting on one thing, particularly if you're dependent on a platform, like all your sales come through Amazon, then that's a big risk.

14:49And you're going to you're going to definitely take a ding for that. Founder dependency as well. Like if the founder is primarily the the generator of the revenue, then that's going to be a problem. And if the business to to receive the revenue in terms of fulfillment requires the founder to perform, that's a challenge. So that's why speaking in guru type businesses have a really hard time selling and sell for really, really low multiples because that's all around that identity of that one person. So those are things that definitely are going to go into it as well. So what are some things that people should be thinking about right now?

15:28They've got a business. They did a few million bucks a year. Solid business. um what are some things that people should be doing right away that are easy low-hanging fruit that can improve their QV I think the the number one thing is is going to be recurring revenue that doesn't churn and and like if I was going to pick one metric it would be net retained revenue like that's that's going to be kind of the you know the the target that we're going to want to keep is that, that, that the revenue that we've got, if we didn't sell another customer is going to continue to grow. And so we'd have, if we didn't sell another customer between all the people we have in keep and the people that they're going to bring in and the growth of their business, um, we're going to ultimately be better off a year from now than we were today.

16:24And so if, if you're over a hundred percent, you know, then that's magic, you know, wonderful, wonderful place to be. And somebody might be hearing this and be like, we're 100 % revenue retention. Basically, I get 100 % everybody to stay and then they bring a friend. But it really is, you get a significant portion to stay, hopefully 90 % plus. And then the ones who do stay, they're expanding. So they're actually spending more year over year. So introducing higher tiers of service is one way. Once you've implemented a monthly recurring revenue model now having higher tiers of service so that people have the ability to ascend.

17:01Yeah, upsells and utilize. And yeah, growth that they like natural growth of them in the business upsells the ability to get a larger share of the business from them. So, you know, perhaps they're using multiple vendors to diversify their supply chain, you know, and so you're one of many, you know, if you can get a bigger share of wallet, that's that's going to be a big deal to them. it's in the inverse of this is happening right now to a lot of SaaS businesses, because part of the reason SaaS businesses are valued so high is because they had massively high net revenue retention. Because these companies would come in, they'd start using like a Salesforce or a HubSpot, and their businesses were growing.

17:42So they need more seats. And now what we're seeing because of AI is a lot of these businesses are actually getting smaller. And so their net revenue retention is going down, even though usage is still, people still value the software, they're not going anywhere. These businesses just aren't growing. and it's just taken, you know, the knees out of the valuation in a lot of these companies just because they're not getting that revenue retention. They're having to figure out. I think it's a good question to ask is in what ways do people value our services that will continue to grow? Because maybe if your business is going to, if the people you're serving, let's say you are B2B, if you're on a seat license and you don't see a tremendous amount of headcount growth in that space because of AI, I'd consider tweaking your pricing model.

18:24Because that's going to be a knock now in terms of your Q of E, whereas before it might have been an improvement. Yeah. The other thing to consider, I think, would be your product range. So, you know, the greatest example that most of us can remember for product range is that Apple had, I think, 13 or 15 products. And Steve Jobs, when he came back and replaced John Scully, he's like, no, we've got two products for professionals and two products for consumers, four total. That's it. Everything else is gone. and it made a big difference in the change of the company. I think looking at your product range and saying, what are our most profitable products or services that we've got and how do we sell more of those?

19:04And should we trim some of the other things off that perhaps are the 80 % of the effort that are only contributing 20 % of the profits? That's like that quality of the margin in the different products and services you have in your product range makes a lot of sense to look at. And then the other thing is, you know, an Apple, uh, definitely Tim Cook has been a master of this. Um, can you add more services on services tend to be recurring, uh, you know, or, or lend themselves more easily unless you've got, you know, a product like toothpaste or cell phone, you know, kind of hard to get people to buy a new car every week, uh, or even every year.

19:46But, um, But if you've got service maintenance contracts and things like that, that you can sell that you're not selling now, or you can increase your efforts on selling more of those, then that that's, you know, those are the types of things that we would be looking at to try to improve QOV. And really similar to exiting, it's better to start doing these things a year or two before you have to get your QOV report because it's hard to make the change once you've got it. yeah when and also so let's say you get a report the report says yeah you suck in these areas so you're like okay we're gonna go fix those well now you gotta wait a year or two to get for the data to show up so even if you decide you're gonna make the changes buyers aren't gonna believe that so and until until the data shows up what about so uh customer diversity channel diversity how much have you seen these be a real knock in some of the qv reports i mean looked at every time it's it's because it's risk.

20:45It's just, it's a straight, like it's a financial calculation of risk. And there's objectivity and subjectivity when you're looking at those things. Objectively, if you've got, uh, you know, a high churn rate, you're losing customers faster than you can replace them. And you'll have to, you know, very often you'll find like, you know, 4 % churn a month. That's 48 % of your customers are churned out, you know, every year and compounding that it's probably higher. Yeah, it's even worse, I think, than that, right? Compact. Right. But let's just say, you know, simple math. If you're losing half of your customers every year, you've got to find a way to replace half your customers every year.

21:21So if you're going to grow just to get growth, you have to be at more than a 50 % growth rate. That's tough, right? So that's, you know, those dings are significant and palpable because the buyers are going to look at it and just and say, you know, okay, so where are those people coming from? You know, well, they're coming from ad campaigns and this and that and the other, and then you're going to get into channel diversity and, you know, blue sky and all that kind of stuff. But, um, it, it, it really does have a significant impact. And like I said, even if you manage to stay in, in the range and get a deal, um, your structure of the deal is going to be significantly less favorable to you in terms of cash certainty.

22:02Um, you're, you're, you know, like if you put a lot of risk on the buyer, the buyer's going to just put that risk back on you. Are there any other big aspects of this? So definitely try to implement some type of monthly recurring subscription-based component. I know that also, if you have contracts, obviously, that automatically renew, that that's meaningful. Somebody would look at that and say, yeah, that's more durable revenue, especially if the contracts are signed by credit-worthy groups. We want to, what are you looking for percentage-wise to show well in terms of customer diversity and not being kind of too...

22:45It depends on the business and the dollars that are involved. It's, you know, but really, if you've got more than 10 % dependence on any customer, it starts to impact. if you've got a high dependency on a small cluster of customers, we have one company right now that's got like 40 % of their income is three or four customers. And that's scary because let's say that they're all equal. And let's say that you had a deal where each of the customers was 8 % of the business and you had five of them. But if you lost those five customers, you'd lose 40 % of your revenue. And depending on your margin and your fixed cost ratio, that could mean you go from profitable to loss, right?

23:33To a losing proposition. So those are things that are gonna, you know, be looked at carefully. What about channel diversity? Is there, is it the same kind of thing? No more than like 10 %? Same thing. Yeah, I mean, it's like, it's hard to say because if you're, and channels are, like if your channel is dependent upon affiliates but you've got a hundred affiliates. That's not going to be as big of a challenge as if you've got two platforms and one platform, Amazon, is 70 % of your business. That's going to be a problem, right? So I wouldn't say it's the same in that like it's more than 10 % because you could have 80 % of your revenue coming from advertising across, what?

24:18Two or three platforms. but if the platforms had multiple, you know, sources as components, like it's Google, you know, then it's going to be less of an issue, I think. Okay. So what else should I be thinking about? Like, let's say I've optimized for, we've got some MRR, and what percentage does that need to be of the revenue to where it's like, okay, this is meaningful? I mean, I don't have enough data to say, you know, I would say that if you are, you know, 50 % or more, that's going to be good. You know, if you're in that 50 % plus range, you know, they would like to see 70, 80. It depends on the type of business too.

24:59If you're SaaS, it's definitely way more than if it's, you know, lawn mowing, but something to think about. So we've got that dialed in. We've got solid customer and channel diversity. We've got good systems and documentation. So the owner, the seller, is essentially out of the day-to-day. So they don't believe that this is necessarily going to be dependent upon them to keep the flywheel spinning. Can we say that that's pretty good? or are there other categories? It's all the things we talked about, but if you have those, you know, it's like anything. They typically look at deciles, you know, like the lowest 10 % and the highest 10%.

25:40You know, if you want to get in the range of, let's say, that six to eight typical opening offer from, you know, a PE firm, if you want to be more in the eight and less in the six, you know, in the higher decile of that, then the more of these things that you've got going for you, the less the risk is to them, the easier it is to get your offer in at, you know, eight, 8.25, eight and a half, you know, and then you can negotiate from there. It makes it so much easier in the negotiating to start at eight than to have to get to eight from six. Cause you know, six to eight is what a 33 % increase, you know, like, and they will be aware of that, you know?

26:17So like, if I can go from, you know, if I can get a, you know, a 50 % increase on an eight, I can get to a 12. If I can get, If I have to get a 33 % increase just to get to eight, it's harder. It's not impossible. We've done it, but it's definitely harder. Yeah, and the people writing big checks tend to have people around them who are pretty good at math. Yes. So you're going to want to have this stuff figured out on the front end. Is there a way, I mean, so if somebody's listening to this and they're thinking, okay, sounds cool. I'd love to get a sense of, I'm not really clear on where we are right now.

26:49I'm certainly not going to go and pay some company$100 ,000,$300 ,000 to do this. is there a way to, you know, load up a bunch of financials into like AI and, you know, have it prompt you on this stuff? I mean, the financials would be tough without the detail that goes behind. But we've got a Q of E light, you know, report that we give to people at Scalable. So we could make that available to people and maybe probably should. Yeah, because I do think that this is, it's one of those things that, again, everybody thinks about EBITDA and they think about revenue growth. But what nobody's talking about and what is going to absolutely be picked apart is this.

27:34Because this is the thing where all these private equity people like Tiger Glow, like they just lost their freaking butt on so many of these deals when they were just throwing money around left and right. They're like, oh, you've got this revenue. We're going to give you this money. And then what do you know that the revenue did not show up after they, after they bought it and they're a little pissed off about it. Let's just say exactly. And entrepreneurs to our, to our credit, we're typically scrappy hustlers that are like, you know, okay, let's get some growth, you know? And so we're so focused on it.

28:07And that's like, that's one of the biggest risks that I don't really see them driving into a diving into that. If I could say, what's the biggest thing that I see in failure of acquisitions by private equity and other companies to realize their value is a failure to understand how scrappy and hustle culture the entrepreneurs that are making that company or that built that company are. because when you replace them as PE for sure will, when you replace them with MBAs and people that are straight out of school and have come from McKinsey and even though they're quant smart, they're not street smart and they will not hustle like an owner that has skin in the game.

28:58They are employees and they don't typically have great vision. They're not entrepreneurs. They haven't lived that. They're not scrappy. They're not gonna work 70 hours a week And so that's to me like that hidden thing that entrepreneurs have going for them that when they sell is most missed. And so even replacing yourself and having a team is designed to make that happen. Having systems is designed to make that happen. But entrepreneurs that are a force are a force. You know, Apple, Amazon, and Tesla do not grow like they grew with all the things they had going for them if they don't have scrappy entrepreneurs, right?