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As we prepare for SOP 50 10 8.1 to go into effect on October 1, it is important for lenders to understand what a Quality of Earnings report is, and when it is required for certain Change of Ownership transactions pursuant to SOP 50 10 8.1, Appendix 15.
SOP 50 10 8.1, Appendix 3 defines Quality of Earnings (QoE) as:
An independent financial due diligence report that examines the reliability, sustainability, and accuracy of a business's historical and projected earnings. QoEs must be performed by an independent qualified financial professional and must be conducted for the benefit of the Lender, and may not be prepared by or for the borrower or seller.
SOP 50 10 8.1, Appendix 15 sets for the following specific QoE requirements:
- For Business Expansion (a change of ownership transaction in which an existing operating business purchases another business is in the same four-digit NAICS Industry Group), and Initial Acquisition (a change of ownership transaction resulting in a new majority or largest individual owner who was not previously employed by, or a direct or indirect owner of, the business being acquired), transactions where the Purchase Price (the price set by the purchase and sales agreement, less appraised value of the portion of owner-occupied commercial real estate assets being acquired in the transaction) is equal to or greater than $3 million, the Lender must also obtain a Quality of Earnings (QoE) in addition to the required Business Valuation. The $3 million threshold is determined before the application of buyer equity, seller debt, or other financing sources.
- The QoE analysis must reconcile the business's accountant-prepared financial statements, tax returns, internal financial statements, and IRS transcript data to produce a normalized, adjusted earnings figure that reflects recurring, arm's-length operations.
- The QoE must include a Cash Proof which is a financial analysis that reconstructs cash receipts and disbursements by reconciling bank statement data to the income statement and tax return for each period under review. The Cash Proof is designed to identify discrepancies in income and undisclosed expenses and must be performed on both a trailing 12-month basis and the last two fiscal years.
- The report must identify and document all add-backs and adjustments to the seller's reported earnings, including non-recurring revenue or expenses, above- or below-market owner compensation, related-party transactions, deferred maintenance, and accounting methodology differences between cash-basis and accrual-basis reporting. The QoE must assess the quality and sustainability of the business's revenue base, including customer concentration risk, contract continuity, and the likelihood that existing revenue and margins will be maintained post-sale.
- The Lender must use the earnings from the QoE in the Debt Service Coverage (DSC) determination and retain the QoE report in the credit file.
In addition to the specific QoE requirements set forth in Appendix 15 of SOP 50 10 8.1, QoEs provide practical benefits for borrower and lenders in Change of Ownership transactions. For buyers, a QoE helps validate the earnings used to establish the purchase price, uncover financial risks, support negoation of valuation and transaction terms, and reduces the likelihood of a buyer overpaying for a business. For lenders, a QoE provides independently supported cash-flow information for evaluating repayment capacity, debt-service coverage, appropriate loan sizing, required equity, and post-closing liquidity of the buyer.
If your lending institution has questions about Quality of Earnings requirements, or any other SBA lending matters, please contact us at SBAQuestions@JellumLaw.com.
This article is provided for general information and educational purposes only. It does not solicit, establish, or continue an attorney-client relationship. The contents should not be construed as legal advice or opinion. If the organization would like formal legal advice, our professional liability insurer (as well as the applicable attorney ethical rules) requires that we establish a formal attorney-client relationship. If you are interested in learning more about working with Jellum Law, please contact us at SBAQuestions@JellumLaw.com.
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