🔑 My friend overpaid for a business (he avoided disaster)
Welcome to The Business Buying Academy with Sieva Kozinsky. Here's what we have in store for you today:
- Market your business with me
- My friend overpaid for a business
- Watch these videos if you want to buy 9 companies
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🔑 Don't overpay for a business - Here's how
I recently talked with a friend who bought an accounting business.
He told me that he overpaid.
What happened?
After agreeing on a multiple of earnings, he realized that some of the revenue was actually one-time and would not continue after he bought the business.
Some of it was a payout from a PPP loan, and other revenue was from clients that had already left and wouldn't be there when the new owner took over.
In this case, everything worked out completely fine.
He's tripled the business after buying it and added more acquisitions.
And he was completely fine overpaying a little bit because it was a quality company (if he didn't overpay, someone else would).
Luckily, he caught these discrepancies during a process called quality of earnings so he knew exactly what he was buying.
If you're interested in my full conversation with him about how he bought the business, you can listen to it here.
All revenue is NOT created equally.
You'll often hear business buyers talk about the multiples of revenue or earnings they pay for a business.
But the deeper question is: What level of quality are those earnings?
Here's a scenario for you:
Say you're looking at purchasing a service business, and you have two companies to choose between.
Both have $1 million in annual revenue and the same profit margins.
But Company A has their revenue split evenly between 20 clients.
While Company B has one huge client that accounts for 60% of their revenue.
Which company are you offering more money for?
Company A is the easy choice.
Company B has a huge concentration risk - you could easily lose your entire investment if that big client decides to take their business elsewhere. Company A doesn't have that same risk.
That's just one example of what a QoE report would uncover.
What is a Quality of Earnings Report?
A QoE report is a detailed financial analysis that evaluates the sustainability and reliability of a business’s earnings.
Unlike standard financial statements, a QoE report digs deeper, assessing the quality, consistency, and risks of a company’s revenue and profits. It’s a must-have for buyers to ensure they’re not overpaying for a business or inheriting hidden financial issues.
Why it matters: A QoE report reveals whether earnings are driven by core operations or propped up by:
- One-time events
- Accounting adjustments
- Unsustainable practices.
For business buyers, it’s a due diligence compass.
Key Components of a QoE Report (these are just a few of the components of QoE, but not all of them).
- Revenue Quality:
- Examines whether revenue is recurring, predictable, or tied to one-off events.
- For home service companies (e.g., HVAC, plumbing, or landscaping), look for stable customer contracts or repeat business vs. seasonal spikes.
- Red flags: Heavy reliance on a single client or irregular revenue patterns.
- Expense Analysis:
- Identifies non-recurring or discretionary expenses (e.g., owner perks like personal vehicles or inflated salaries).
- Highlights cost structures that may change post-acquisition, such as rent or supplier agreements.
- Cash Flow Sustainability:
- Assesses whether cash flow supports ongoing operations and debt obligations (this is especially important for SBA loan-financed deals).
- Checks for working capital needs, especially in service-based businesses with high inventory or labor costs.
- Adjustments and Normalizations:
- Adjusts earnings for one-time events (e.g., legal settlements, COVID-related subsidies).
- Normalizes owner compensation to market rates (important if you're hiring an operator).
- Risk Factors:
- Identifies customer concentration, regulatory risks, or pending litigation.
- For home service companies, evaluates equipment condition, technician retention, and local market competition.
Pro Tip: Hire a reputable accounting firm to conduct the QoE. Costs typically range from $10,000 to $50,000, depending on the business’s complexity, but it’s worth every penny to avoid surprises.
What it means for you
When you're buying a business, you might offer 3x earnings for a small home service business. But not all earnings are created equally: You need to make sure you're paying for the right earnings.
I'd rather pay a 5x multiple for a business with quality earnings than 3x for a business with bad ones.
If you're not analyzing the quality of revenue and earnings, you might be making a poor investment.
🔑 Watch this if you want to buy businesses
Over the last couple of months, I've narrowed the focus of my podcast.
I spoke to some of the most skilled business buyers I know and dove deep into their strategies for finding and closing deals.
The advice they share is worth millions.
A few of the recent lessons shared on the show:
- How Rafael bought 9 companies
- How Brian bought a 7-figure business with 100% seller financing
- How Chris doubled his flooring company's EBITDA after buying it
If you want to buy a business (or nine), you need to watch my most recent interviews.
And if you haven't already, please subscribe to the YouTube channel.
Have a great day,
Sieva
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