Financial Due Diligence Secrets Behind M&A Deals with Jonathan Hutchins

Everybody, welcome to another episode of Still Searching with Jed Morris. Today, my guest is Jonathan Hutchins. He's the senior manager at Ascenti for corporate strategy, M&A due diligence, finance and process improvement. Jonathan, he basically does M&A finance due diligence. He works with deals as small as a couple hundred thousand dollars, all the way up to 50 million to 100 million all across the middle market. I'm really excited for Jonathan to be here and to help just talk to us a little bit about what it's like in financial due diligence and the things we should be looking out for. Thanks for being here, Jonathan. Thanks, Jed. Yeah, I appreciate the introduction. Yeah. Well, I'm excited. I've always just started off with you letting us know a little bit about your background and how you got into financial due diligence. Yeah. I'll go way back. I was born and raised in Tulsa, Oklahoma, and then went into audit services out of an accounting degree. I started realizing that the nitty-gritty of accounting was interesting and a good foundation for my career, but really wanted to get into the more interesting side of the world. I actually

did a multi-billion dollar carve out when I was at EDIY in audit, and I was like, "This is so fun. I want to do this." That was my first introduction. I did on the audit side, but that was my first introduction into the finance side of it and the Q&A and the carve out audit world that I did. That got my wheels going. I started looking around and realized there wasn't financial diligence practices in Oklahoma. I ended up shopping around and finding a home at EY in Atlanta. I made the move out here back in 2019. I did four years, four busy seasons in audit, and then made the move over, which is a pretty traditional, so for folks who are sort of learning about financial due diligence, a lot of those folks come from audit. Some of them are the CFE, CFA role, finance backgrounds, but call it 90 percent are CPAs by trade, accounting by trade, and then they move into financial due diligence, kind of a natural role, similar to almost like a move into FP and A. Yeah, that makes sense. You have your degree in accounting, but you didn't get the CPA,

right? I did get a CPA, yeah. Oh, okay. Yeah, so I'll rewind a little bit. I did a bit of an atypical move, which was instead of getting a Mac or a master's in accounting in order to get my hours for this CPA, I just decided to get an MBA, but did it straight out of college. I didn't do what people should do, which is go get two or three years of experience, go to a big school, and then have that school launch you into something else. I just went straight through and then basically came in as an entry-level individual with an MBA, which in hindsight was rather silly to do, but it worked out okay. It seems like it worked out okay. Now you're in Atlanta, and you basically made that big pivot getting you into deal sourcing. I hear this a lot too, and to be honest, that happened to me. It's like once you get that first taste of how deals are done, you're like, "Oh, man, this is cool. This is really great." You got bit by the bug, went to Atlanta, and now you're just neck deep in deals. Yeah, so I really dove into it pretty blindly. I hadn't really worked with any core diligence

folks prior to that, even when I did the audit side. I hadn't really touched on it. I got bit by the bug a little bit then, just basically dove in and just was like, "This is what I'm going to do, and I loved it." I very quickly learned that that's how my brain ticks and operates, and that's how I think about the business world is in a little bit more of the finance, a little bit more of the strategy and operations side, which I think is what a lot of those practitioners in the world of what I do need to be able to think about beyond just the debits and credits of the accounting that you build. Think about how does that actually translate into operational outcomes, and how does that impact your P&L and the business balance sheet and cash flows? Yeah, I loved it, and now turning back since then. No, you're exactly right. I think this is the part that a lot of people miss, and it's one of the things that I also want to motor and the evaluation professor at NYU talks about a lot. He's like, "You have your quants, and you have your storytellers, and the quants want all the numbers to make sense so they can have a rational explanation, and the storytellers,

they ignore the fundamentals completely and just tell you about where the business is headed." He's like, "The true answer is that it's actually a mix of the two. You have to have the financial foundation, but then if I don't understand your story, then the finances don't make any sense." You have to actually find a way to combine the two and figure out what's the true story of this business and where is it actually headed? Because neither of those two, the storytelling or the financials in isolation will get you there. Yeah, and that's a great transition into the world we live in. We have the investment bankers who are the storytellers, and then you have the controllers and stuff at the business who see the numbers, and then we slot in the middle of, "How does these glorious performers in the hockey stick of the business hit reality? How does that translate into both a forward-looking view as well as how the business has performed historically, and is the way that business has performed historically, actually align with the way that the bankers are articulating. I say bankers, I know a lot of deals are unbanked, but even in the lower

middle market space, I feel like there's still a lot of investment banked deals, even if it's a smaller bank firm versus a bear or a Goldman or someone else, there's still lower middle market banking providers who try to tell the same story of your business. We really see that in your right. You don't really see the bankers involved in the SVA level deals, but once you get over that $5 million EV, then they tend to start playing along a lot more because they can do that. They help tell that story. Let's actually dive into that piece right now. You're doing financial due diligence. You're helping small businesses understand how to tell the story of both their finances and the direction of the business, whether it's because they're being acquired or it's a larger business looking to acquire another. A lot of these businesses, what's the range you're working with? What's the smallest types of businesses all the way up to the largest deals? I think smallest, I'm working on a deal right now. It's a $300,000 EV. It has about $1 million

in sales. Wow, that's small. Yeah, so we'll go as small as that. I've done maybe one or two deals smaller than that, but that's about as ... If you go much smaller, your risk to fee ratio starts compressing quickly. Then as high as deals of ... Pretty common to be in the $50 million range, but I'm working on a couple ... In the last couple of months, I've been close to $100 million, but that's the spectrum. Call it really $5 million EV, so that $5 million above the SVA level all the way up through $50 million is pretty common range for my firm. Yeah, that's a pretty broad range. The big takeaway I have is that if you're working on deals that are on the smaller side, whether they're SBA-sized deals like $1 to $5 million or even a $300,000 deal like you just mentioned, all the way up to $50 million, now that's still squarely in the middle market, but they feel like they'd be a lot different. If you're working on a small $300,000, $2 million total-sized deal and a $50 million deal, they feel like

they'd be a lot different. Are they really that similar? Yeah. I would say the thing that really drives the complexity, I would say, is the industry less than the deal size. Within specific industries, you'll see manufacturing. You have Costa County of complexities there. Within software, you have the quality of revenue, SaaS implications. In deal size, you see less difference. Honestly, the smaller deals, you typically have a less sophisticated accounting background running the business. Quick books, if you're lucky. Quick books typically like the wife of the owner or the owner themselves or the husband of the owner. If the wife is the owner, it doesn't have to be right. It can be both ways. You get lucky. They may have been an accounting degree in college and you're like, "Sweet. These books are in order." You may get lucky and they have no idea what accounting is and they're just putting things into QuickBooks the way that QuickBooks says they should be categorized, which is okay. Obviously, as you get more volume of customers

in a deal, complexity does increase. But the issues around revenue recognition, quality of revenue, you're validating that. You're actually getting cash in the door. The nuances of looking at headcounts and the other SG&A components, looking at your margin by customer. All those things exist at both a small business and not a large business. That makes sense. As I'm thinking about it, it would feel like a small deal dollar-wise would be a lot different than a bigger deal. But in reality, it's not so much the dollar size. It's the industry. That makes sense. Some industries are heavily regulated. Some, like you mentioned, manufacturing have a lot of cost accounting. I can think of healthcare. It feels like it'd be one that have a lot of regulations as far as the type of information that you're tracking. But yeah, it's less about the size and more about the industry.

Interesting. Yeah. And I will say, obviously, if you're working with a business that has 50 customers versus one that has 5,000, there's going to be a time differential on how quickly you can get through it. So the one that's 50, that's a small business. Or ironically, you could have a 50 customer that's huge in revenue because they're really big customers. But assuming that small business is the one that has 50 customers, you're going to be able to get through the work on a quicker time scale than you would if you're analyzing a 5,000 customer business. And you're looking at concentration risk of that and you're looking at price volume analysis across those other metrics. There's definitely going to be more of a lift for a bigger business if you're thinking about the duration, the intensity, and the fee related to it. But there is kind of a baseline minimum. You have to do on every single deal and that baseline is here and then you can have deals

that range anywhere up and down from there. Well, that makes sense. Let's jump right into that then. Let's assume like in financial due diligence is one of the areas that especially first time buyers have a lot of questions about, obviously. It's like we understand that there are other important things in due diligence, but finances are kind of like the bread and butter. They're the foundation. You need them to be able to do the deal. That's the basics. And regardless of what people say, what I have found is that the vast majority of buyers are, they're not very sophisticated when it comes to finance. What I mean is that the best ones have a pretty good understanding of revenue and gross margins and net income and what their EBITDA looks like and how to track all that talking finance. Most people kind of shy back a little bit. You're nervous. And so I really want to dive into this from the perspective of, hey, I'm a first time buyer. I understand some basics of finance,

but I'm not a Wall Street guy. I'm not a deal guy or gal. And I want to make sure that I can understand some of the basics I should understand as I'm working with a professional because if I'm buying, I'm going to work with someone like you or someone who's providing a quality of earnings. And so I understand it's not going to be me diving through the numbers, but I also understand that I'm ultimately responsible. So I have to understand what you're telling me because I'm the one who's going to fundamentally make the decision whether or not to buy this business or not. So let's look at it from that perspective. I'm a brand new buyer. I've got a decent understanding of finance, but I'm not a pro. I definitely don't have my degree in accounting and I've not worked in M&A due diligence. So I find this business, let's say for argument that it's on the high side of an SBA level. That way it's not super tiny. Let's say it's four or $5 million enterprise value. What are the first things, like what are the foundational things that I should be looking at or that you're going to be looking at and just start looking at these deals? Like what are the bread and butter? Yeah. So, you know, assuming they're in sort of target identification stage pre-LOI, right?

You want to be looking at a couple of things. One is how is it trended historically, right? So what is top line revenue done? Like is it producing? Is it growing? Is it shrinking? Is it flat, right? Step number one, two, what is its gross profit, right? Because gross profit is super important. You can only cut costs to a certain level in the SBA side if you don't have a high enough level growth gross profit that is at or above industry average. So one, you need to be able to have someone you can call on in the industry who knows what the gross profit should be, right? Because you're like, oh, it has a 50% gross profit, but it should be a 75. You're like 50 sounds great. And then you're like, oh, wow, this should be a 75% gross profit. I see that a lot in services, too, because you'll find businesses that have a gross profit of like 25 or 30%. You're like, oh, that's actually not so bad for HVAC or whatever the business may be until you actually speak with someone who's in the industry and like it should be closer to 50. And so the question then becomes, is it not at 50 because the business

itself is being mismanaged or is there some sort of underlying problem? So that is a very interesting question because it can sometimes be as simple as they're not putting the right cost within cost to gross. Yeah, they haven't increased their prices in 10 years. Well, it can be two things. One, they haven't increased their prices. Two, they haven't managed their vendor relationships. Or three, they're coding things to COGS. That should be an SG&A, right? Oh, that's a good one. Yeah. And so it really can be... So then the next step is what's your EBITDA contribution, right? What's your gross profit down to what's your EBITDA? And if your percentage, if you're generating like a 2% margin on the bottom line, you're like, okay, well, then not only is COGS probably under what the industry should be, there's probably also a lot of excess SG&A that is also an issue, right? But if they're like, hey, our margin's at 50%, it should be 75. But from the gross profit down to your EBITDA contribution margin, you're

like, hey, I'm at 50% and I'm at 30%. You're like, wow, 30% is phenomenal. That means there's probably just a lot of sitting in COGS that should be down SG&A, right? Yeah. And that's actually what you want to find. You just misallocated how you're actually writing in your COGS because that gross profit, we're supposed to be removing all the SG&A. We're supposed to be saying, hey, this is the profitability of business operations. Assuming everything else is going fine, this is the profitability of the business itself outside of all the admin stuff that I need to keep it running. And if I'm putting that admin stuff up in the cost, then it could be a much more profitable business. I'm just not accounting for it correctly, which makes sense because we know that a lot of small businesses, their books aren't great. And even if they are decent, like you said, they're probably an owner or an owner spouse or some or bookkeeper who could just be simply putting those costs in the wrong place. Yeah. And what you'll find is you'll find it going both ways, right? Where people have,

it's mostly people, right? So if it's a materials business, materials purchases generally end up getting in cost goods sold, but sometimes they'll just throw all the headcount costs up in the COGS or they'll throw all of them down in the SG&A. And you're like, okay, look, you're really like your controller and your office manager and thinking about sales and marketing, right? Like sales and marketing should be in G&A, or broadly, right? You could have a sales marketing group, but I'm calling G&A everything below gross profit, not up in cost of goods sold. Cost of goods sold should be the people actually, if you think of the HVAC business you mentioned, I think, might have been the example you gave, right? Like your tax are the ones that are up sitting in there and your sales folks and your area managers, those might be down in G&A versus up in cost of goods sold. And that's where folks like myself can sort of provide a bit of like a benchmark based on what we've seen in other deals, what we've seen in the industry of where cost should be and then is this above

or below where we would expect a profitability of this business to land. That makes a lot of sense. And to be honest, I think a lot of businesses categorize that incorrectly. And I think about like, I owned a landscaping company at one point and a lot of blue collar service businesses, labor is the number one expense. It's a number one cost by a long shot. And supplies are expensive, but labor is by far the most expensive. And almost always the labor is either completely up in cogs or completely down in SG&A. Very rarely split. And so if, first of all, if you don't realize that those should be split, then you're not getting a clear view of your profitability. And then second, once you realize that they should be, you know, as you're getting those, if you're buyers, as you're looking at Sims or as you're talking to business owners and you're looking at their financials, like you got to do the diligence ahead of time, you know, pre-LOI, if you can get the financials and just be like, all right, well, what do I think the actual finding, what is the actual profitability of the business? Like, it's clear that, you know, because they've misallocated the largest expense that they have, they have a skewed view and that could give me an advantage.

Because now I know what this business is actually, how much cash it's actually generating. Yeah. If they're going back to your original question, it's like, what are the things you should be looking for, right? So it's, you know, it's, what is it, what is the diversity in product offerings, right? Okay. Are they concentrated with one specific service? Okay, maybe that's good. Maybe that's not right. Like, where is the revenue coming from? Can you, can you get a customer listing? Even it's redacted, right? To know customer concentration, and then, you know, the ability to get gross profit by customers to see if there's an anomaly in there to understand if a specific customer is really driving a lot of their EBITDA. Yeah. And then from there, a lot of these small businesses, I want to know who's, who's a day-to-day GM? Like, who's, who's the person actually out there boots on the ground driving customer relationships? Because if, if I'm coming in, if I think of like an ETA model or some of these other models, even, even a private equity model, right? Where you're either wanting to transition owner out or, you know, outright replace them within a short period of time.

You want to know, and I've, I've seen this on deals I've diligence on the buy side where they did a bunch of add-ons and they didn't properly identify who that sort of key man was and that key man departed and then relationships went with them. And then they, they realized that after the fact, right? And they're like, well, why is my business shrinking now? And this was, there was a property maintenance company I did diligence on that ended up dying. And it was sort of a conglomerate that rolled up a bunch. And they had a couple, I would say happenstance where they had a couple ones where the, the second in command was actually the one that could step into that relationship. And the other ones that there was no second in command. And when the primary owner sort of phased out, they just started to like revenue was declining 20% year over year declining, which is, you know, not the, not the direction you want to be going. And then, you know, on top of that, they didn't have a good handle

on, on margin by product or by category. And, and so we came in and we're like, guys look like these are all the flags we're seeing. Like, and not only is it shrinking, we can't even tell you to our client, we can't even tell you what their profitability of the product lines they do have is because the data doesn't exist. Yeah. Yeah. I mean, that's a whole another story of like deal readiness and everything that goes into that, but But you're hitting on something critically important, which is the key man risk. And a lot of times, you know, we think about the owner being that key man risk, which they absolutely are. But, you know, you also think, but the very next thing is like, which of the key employees are really important. And this is a, this is something that's really important, especially like, you know, for all the reasons you just mentioned, you know, relationships go with them, profitability goes with them. But also when you think about how first time buyers, you know, a lot of times they're buying in an industry they don't have direct experience in. Right. And so not only are they, you know, when they buy, now they're, they're buying in this industry, they don't understand the industry. And they're learning about the industry. And at the same time, learning how to be an owner for the first time, which

is its own, you know, vicious learning curve. But now they've got, if they've properly identified one or two key men or women like key positions in the business, and they're kind of stuck with them. Like they have to, they have to really kind of like nurture those relationships very critically. Because, you know, like you said, one or two of those people leave and now you're, you're stuck. And, you know, especially if you're buying the business that you don't have experience in, it's, it's going to be much more difficult for you to roll up your sleeves and do that work yourself. Yeah. And so that's, that's a little bit. So I mentioned that it's a little bit outside of the wheelhouse of a QB provider, but I put on my operational hat on every deal, which is like, what, what are the risks outside of the core financials that I want to be, you know, telling my client about. And so, you know, a lot of these smaller deals, so the sub 5 million EVs, it's going to be three to 20 people at the business, right? So it's going to be small, kind of a small core group of people. Likely we're going to be talking to the owner, maybe the owner and a plus one, right? But those are the type of

questions that are like, Hey, like, what is your day to day look like? Are you out on the field? Like what, what, what is your mix between administrative roles and client facing roles? Like those are the type of questions that on the, especially the smaller deals that we'll kind of throw into our kind of core question list that we wouldn't necessarily need to do on, you know, 100 million EV type deal because they're going to have a president, a VP of sales, like all these a suite of people who own the relationships that can, you can just give them a retention bonus or whatever if you need to, to retain those. Whereas on the smaller deals, it might be, it really might be that one person who owns that versus a handful of people. And if one of the handful leaves, you can sort of absorb that into the remaining group, but not so much on a, on one of the smaller deals. Yeah, exactly. Right. So, so let's run these down. So first words, you mentioned how, you know, checking revenue direction, is it trending up? Is it trending down? Is it flat? Checking gross profitability? Like is the operation of the business actually producing money?

And then are you aligning your, are the costs aligned correctly so that we actually get a clear look at gross profitability, right? Key man risk, making sure that we understand like who's actually got the relationships, where the actual profitability business is being driven from and identifying that person correctly. Cause you're right. The last thing you want to do is buy a business and then all the, you know, all the customer relationships, the supplier relationships, the vendor relationships, all those walk out the door as you're taking the keys, right? Man, I could definitely see that happens a lot, especially like, especially like a roll up type deal where you're, you know, you're just buying quickly and, and maybe not checking for those key individuals as thoroughly as you probably should. Yeah. And I'll add one more item and this more sits in the, in the GNA portion. But how married, for lack of better words, is this business with the owner's personal expenses, right? And, and so there's two risks that exist there. One is in this, this is almost a risk that sits more on the seller side, but it's like, is EBITDA as reported understated,

right? Because there's actually their private yacht or, or that's a real example or, or other things. I've met an owner who had a, who had a, a jet in his, as an ad back, cause it was a, it was a, it was a manufacturing company that manufactured airplanes, like test planes and he had his own plane. I get it. Yeah. Yeah. No, I, I'm not going to digress too far, but yeah, I did a deal out of California and, and he actually had a yacht with a captain on payroll and a crew all on payroll that it was, it was a larger business. That's a great life to have. Yeah. It was, it was a great life to have. Yeah. They, he did very well for himself. It was a steel business out west and, and they did, you know, a lot of the larger skyscrapers and buildings and things out there. But, but yeah, like is EBITDA as reported understated, right? And, and maybe the owner doesn't even think about it. And so that's, you know, that's a potential upside to a buyer, but, um, the risk you could run is that you do an LOI at, let's just say 500,000 of EBITDA and then you get in and you start asking questions and the owner wises up and

realizes, oh, wow, I actually have a million dollars with EBITDA and they try to reprice, right? Uh, or you, you, you know, you do your homework up front and then you could, you could, you know, know, going in, Hey, this is really what the purchase price is going to be more ballpark, right? So that's always a question. And just, you want to ask kind of in front of like, you know, I'm not, I'm not a tax, you know, I'm not the IRS, right? I'm not asking from that standpoint, which that's a whole nother set of questions, but uh, you know, do you run your Amazon account through here? Do you run your personal cars? Do you, uh, all your groceries, you're like your vacations, right? Like, and the answer more frequently than not is yes, we do. Um, and then, you know, that's something like myself can untangle all that because it is very oftentimes it's very much just booked in with everything else. Um, and so you'll have a dozen or more GL accounts that have personal stuff, just, you know, completely interwoven into it and you have to pull it all out. Well, and that makes total sense. And you see it all the time, especially in the smaller

deals, the 5 million and below deals, because you have every tax incentive to do it. And if you're a small business owner and you're not running as many of your personal expenses through the business, I would argue you're probably not taking advantage of your opportunity. Um, right. But that's where it comes really, you have to be really, really clear about like, you know, which of these items is an ad back in which one isn't. And then one additional risk. I love how you talked about like the yacht, right? And like, Hey, this could be understating even to buy a lot. Well, the flip side of that is, you know, like if you have something like an airplane or a yacht or a sports car and maybe the owner has been, you know, it's the owner's, you know, item, but then they've been using that as marketing. And maybe that's one of the ways that they're getting a lot of like their business relationships like, Hey guys, come out on my yacht for a while. And that's how they're making those deals. Well, then maybe even as overstated. So as the buyer, you kind of have to be wary of like, what are these ad backs and how are they really impacting the business? And that's an asymmetry of information that you, a lot of times you just don't have. Yeah, no, you, you see that a lot. Like one of the things I always like asking even when

I see like donations expense, right? You're like, okay, well, that might be a, it's where you consider just a no brainer ad back, but it's like, well, are you getting advertising at the, at the Gala's, right? Or are you doing different things? And like the answer is often yes, right? And so it's like, okay, well, maybe that's not a full ad back. Maybe the one going to the local college, maybe that one is right, but the one that's going to the chamber or something, something where they're like up on the parade, right? Like, and there's a banner out there. That one may be not, right? And so yeah, great. That's a perfect example, Jed. Okay, so that makes sense. These are the foundational things that as a buyer, I should be looking for. What are some, some critical red flags that I should pay attention to. And maybe they're not like, you know, deal stoppers into themselves, but what are the things that when you see them, you're like, okay, that's a red flag, we have to get an answer on that right now, because it could be a deal killer. Ooh, that is a that there's so many things that that pop into mind. So yeah, I'm going to give a couple, maybe examples from a recent

deal. But I mean, one is, does it is a data different than what management told you, right? So like, that's one red flag, which, which is, Oh, yeah, we're like, you know, I'm going to take a, I'm going to change to a different thing. Like, so I'm going to go to SAS. So for like, Hey, we're in a software deal. Oh, yeah, you know, we're growing great retention. We've had minimal churn, right? And you get in, you're like, guys, you're having crazy churn, right? Okay, big red flag, right? So it's like, if the data doesn't line up with the narrative that management told you, regardless of, you know, SAS, whatever any industry, that's a red flag. Yeah, because the question then is like, you have to put your EQ hat on and you have to know, is management lying to me? Or do they, or do they not understand how to track their own data? And both of those are red flags. Obviously, in my opinion, if the owner or the manager is lying to you, that's a, that's a, I will not move forward. That tells me that there's a, there's a, there's bad faith. And if there's bad faith in one place, there's

bad faith in other places. And this is not worth the risk for me as the buyer. But the other part of that is like, you know, if their story isn't matching the data and it's because they don't know how to track it, then I'm like, well, you know, I have a whole another set of questions like how much of their other data is just tracked incorrectly? Are they really that incompetent? Yeah. And so I feel like a lot of the other flags, what we'll get is oftentimes when there's like a sell side advisor involved. And so these would be a little bit bigger deals. But and these are more like, all yellow flags, which is where we're getting, and these are things we raised our clients early on, we're getting in. And, and so they've, they've probably priced an LOI off of, off of, you know, another, another provider's EBITDA, and we get in where like guys look like one, either the other provider said, did not diligence management's estimates of something, right? And you're like, okay, well, clearly they didn't diligence it because there was nothing to diligence, right? So that's a super squishy adjustment. Or you get in and you realize things are just very seller friendly, right? Where, you know, I've

a recent deal I did, there was a upcoming restructuring that was going to happen. And it was like a million dollar ad back on like a 10 million dollar deal. That's material. Right. And so like, you know, we're like, Hey, you can get credit for this, but they better have actioned it before you guys close, right? And, and ideally actioned it where you can see that the business can operate for a couple months under that before you guys close, right? And so, you know, and that was an ad back that, you know, they, they had on the seller's Q of E item and we evaluated it. Actually, it was supportable, right? Like the heads and the numbers all matched up. But that was, you know, it was a maybe not like a yellow flag, but it was like, Hey, this is something that we would want to raise of like, if you're valuing off of this, like, so things that are in a Q of E, they've yet to be actioned, right? That are put in as if they're supportable are always, you know, something that raise

a little bit of a flag to me. That makes a lot of sense. And I just realized that we're talking about, you know, red flags that you find in the Q of E. Now, what would you say to buyers who are trying to decide whether or not they want a Q of E at all? Yeah. So, I mean, I would say, unless you're someone who is a former sort of practitioner in this world, aka, you know, someone who's done due diligence or is a former investment banker and has done deal models and things like that, it understands it very deeply. You should be partnering with someone who lives in that world, right? Because it's just a different way of thinking about the financials that most people don't have the time to do when they're sort of evaluating a deal from a, you know, as a buyer's perspective, right? Because they're having to negotiate the purchase agreement. They're having to, you know, keep the seller happy. They're having to think about the operating model going forward, thinking about in a great, like all these other things that where their head is at, they don't have

typically the time to dedicate to truly do a deep dive into the underlying financials. You know, 50%, well, maybe 70% of the time, the EBITDA will end up checking out about where you thought it was, which is in my mind, okay, that's actually good, right? It's like it means that there's actually... Right, you verified the cash flow. Correct. You actually verified it. Like, that's what you want, right? And so, you know, some people were like, well, it checked out, so I didn't need to hire you. And I'm like, no, you hired me for the 30% of the time that it doesn't check out and you're going to get, for lack of a better word, screwed if you don't hire the person, right? I love that you said it like that, Jonathan, because that's exactly the conversation I have with searchers. And I understand that I was a self-funded searcher at one point, you know, where I had some cash, but I was really leaning on the SBA as my primary debt vehicle to buy. And when you do that, you're always pinching pennies, and you're terrified of debt deal cost. But what I see now a lot of times, and I'll be honest, I was in this camp too, when

you're so okay, you're so eager to sign on the dotted line for $3, $4, $5 million of personally guaranteed debt to buy a business. But the idea of spending $20, $30 or even $40,000 out of pocket for a Q of E to make sure that business is actually what you think it is, like, it's so hard to get over that hurdle. And I tell people now, I'm like, look, if you're not in a position to pay for a Q of E, then your whole philosophy of risk is incredibly skewed. Like, you'll sign for all that debt, but you won't pay for a Q of E. Like, do you realize like $4 million of debt hanging around your neck personally guaranteed, but you won't spend $40,000 to figure out if it's actually legit or not? Well, and I'll tell you what, so I almost say, I'm making this number up, let's say eight or nine times out of 10, we'll end up paying for our fees in true value given back to the buyer. If that's an identification of an item that should be treated as debt as a reduction to the enterprise value, assuming, you know, so taking a step back, right? So Q of E, networking

capital debt, right? So depending on the structure of the asset deal or an equity deal, and sort of, if they're, you know, they may or may not have a working capital construct, right? But between Q of E, working capital and debt, there's oftentimes a $40,000 item will identify in debt that boom, fees paid for, right? And then there can be a Q of E item, and we've, you know, it's sometimes a Q of E you won't reprice, right? So it depends. A Q of E is one where there's less, there can be less intrinsic direct value to a buyer, because if you're like, hey, we thought EBITDA was $2 million, you're like, actually it's $1.9, they may still go through and buy the deal at two for more of like a handshake kind of agreement standpoint, even though there's maybe they'll shift some of it to an earnout or there's other ways to structure it, right? But you'll see, yes, they usually have a pretty big miss from an EV standpoint for someone to restructure the deal, because if you try

to retrade after an LOI sign deep in the diligence, it's sometimes viewed as- You burn a lot of trust doing that. Bad faith, right? Yeah. Exactly. Yeah. And, you know, there's obviously two sides of the coin there, but you definitely see more direct EV impacts from a debt standpoint. I'll give a great example and this would be on an equity deal where we, through our diligence learn, they had recently changed their practices around vacation and they had gone from a, let's call it 120 hours a year policy to unlimited, but they had grandfathered in all the people, so they still had the old amount that could be paid out upon departure. We were able to negotiate that as debt, the full amount of that, like dollar for dollar. Oh, that's great. And that paid for our fees like three times over. Yeah. And so it was like, I can remember it was, it was in the hundreds of thousands of dollars of accrued vacation that we're sitting in. Which essentially is just a line item for accounts payable. You agreed you were going

to pay it. Yeah. And so, yeah, you can add that into the actual enterprise value of the business and they're like, "Well, that account payable that you were able to identify and agree is three times more than our fee." Yeah. Yeah. That's great. Yeah. And it was funny because ones like that are, like, that's a gray area. So like from a diligence standpoint, I've seen those go both ways and I've negotiated them both ways, but we threw it on the table and we're like, "Hey, we told our client this is gray. They should likely be giving you some fraction of it up to the full amount." And they took the full amount and they just said, "The seller said, okay, we'll pay you for that." And we're like, "Cool." Yeah. And that makes total sense. And it's like, whether, that's a great example, but I tell people all the time, it's like, you know, these types of deals, especially in the lower middle market, it's the wild west of capitalism. Like it's whatever you guys agree to. And so, you know, the seller and his, and their advisor, they have their idea of the financials of the business, their own, you know, if they've done a valuation, they have their own idea. It's up to you to have your own so that you can come together and find out, you know,

what are the things that each side is willing to trade on and figure out like how you can get a deal done. And I really like how you talked about how like, you know, there are some things here that we can make a deal on. We can say, "All right, well, you know, all this leave that you promised to pay your employees, you know, we can negotiate that as debt and that way we can help pay ourselves back in the actual price of the business." But then on the other side, you're like, "All right, well, although that all that is true, you're also managing the relationship with the seller." Like you don't want to get to a point to where like, you know, if your Q of E is off by a little bit, you know, then is it really worth retraiting the deal? Are you skipping the forest through the trees? Like, you know, if you're like, if you're like, "Hey, maybe we don't agree and maybe the business is worth a couple hundred grand less than I thought it was." But, you know, I'm going to get that even once, once way I'm able to buy. Like really, what are we actually buying here? It's, you know, it's a great analogy I saw is like, you know, we were going to buy our home in San Diego during the pandemic and the home price was $900,000, right? And so we're going to buy this home

and, you know, we had a couple of things go back and forth and we knew we wanted the house and the seller was like, "Hey, $9.20 is our price." And we're thinking, "That's okay, cool. I'm not going to argue over 20 grand on a $900,000 purchase because it's like an extra, what, $1.20 on my mortgage?" Like it's not a, this is not material. There's no point in arguing over this. So don't, don't miss the forest through the trees when you're looking at, you know, it's not about scraping by every individual penny. It's about really getting a grasp of the actual financials of the business. So you can have a real conversation about like what is valuable and what is not valuable. Yeah. No, I completely agree. The one caveat to that will be if you have a seller who is well represented, meaning they have a really good transaction attorney and a really good banker and a diligence team with them, you want to make sure you come equally armed, right? And so I've seen deals where one side was sort of, you know, David and Goliath analogy for lack of better words. And, you know, I could see one side just pushing around the

other, right? And so I, that was back in my EY days. And I was, it was, it was a, it was a huge client and, you know, EY is a huge firm and we told them, "Look, they're pushing you around." And this was an EY client at the time. And, but, but they were okay with it. They wanted to get the deal done. They were, they were willing to get pushed around a little bit and lose a little bit of value to get the deal done. And they ended up doing the deal and probably losing tens of millions of dollars in, you know, in purchase price because of it. But they, they got the deal done and they were, I guess they were okay with that. And, you know, we advise them repeatedly throughout the process of like, "Look, guys, you're, you're conceding here. You should, you should hold firm. You're conceding here. Market is this." And they're asking for this. You should push them back down to market or even under market, right? And so that's, that's where having, being well armed from an advisor is they can tell you, "Hey, what the other side is doing is, is atypical to market. They're, they're pushing you in a way around debt, around, you know, restructuring the earn

out or retreating something late in the game or even how they're structuring the purchase agreement that is not in line with market that is detrimental to you and hold your ground. Do not give on this because, you know, this is an area that you can get burned if you, if you give on it. And they probably know that and that's why they're pushing on it. And so that's where, you know, not just myself, I mean the suite of people around you, not just an attorney, but a transaction attorney, right? And then to the extent you need a tax advisor and to the extent you need someone like myself in the financial standpoint, at least those three on, on any given deal to me, even to a small degree, right? Even if you're like consulting for a few hours, right? You should have those folks around a deal structure. That is such good advice. I feel like that portion alone makes this entire conversation worth it to the listener because you're exactly right. I mean, especially if you're a first time buyer, like if you're, if you're going into the transaction, you need, you need really

good financial analysis. You need to come to the table armed, so to speak, right? With a great Q of E, good financial analysis, an excellent transaction attorney. I'm glad you said that, not just an attorney. You need a transaction attorney who does these types of deals in this type of market for you, for you, your type of client. That way they're well versed in what they're doing. You need to understand your tax strategy. But the thing is like you bring these people in because they're experts, but that doesn't abdicate your role as the buyer. You're the, like you said, you're the one making the ultimate decision. Even when you're EY, you're like, Hey, they're pushing you here. They're pushing you there. If you don't educate yourself as a buyer to understand what is market, what is correct, what I should be expecting, like how all these deals come together, then your, your seller can very easily push you around and half the time you won't even realize it. You'll be so eager to get a deal done. I see the deal fatigue happen quite a bit. You're like, oh, this is a great business. I just want to get this done. You know, and I'm okay with giving up a little bit of value to get the deal done. But then before you know it, you gave up like a couple hundred grand and working capital and you're like, yeah, and you're dead on arrival.

Yeah. Yeah. And so that's, that's where, you know, as, as you're getting down to what I call the five yard line, there, there comes a point where me as an advisor, I'll start telling my client, look, I've given you all the advice I can give you. Now it's commercial negotiation that becomes a point in which it is truly commercial negotiation and you have to just gauge how you can get the deal done. And so there is a point in which that just needs to happen, right? Because if everyone is always just quote holding their ground, you literally will just have the parties walk away. So to me, it's hold your ground hard as long as possible until you get to the point where it's like, hey, we're at the five yard line. Someone is going to have to give somewhere. And you just hope it's, you know, on a small thing, not on a big thing. And you just, you know, get the deal across the finish line. And that's where, you know, you can lean to your advisors to guide you on how much value am I truly giving up. Maybe it's not even a quantifiable amount. Maybe it's an unknown future or something. Maybe it's, you know, a change to your structure in the air and

out of, you know, what does this implication have or a change in how you're structuring, you know, the tax stub period or, you know, I have a whole bunch of conversations around that of like, if stuff is done pre pre closed, post closed, which period it goes into, right? And how people can finagle with, you know, pre and post closed tax returns of being advantageous to their, you know, their taxable income and things like that. But there's, there's all kinds of fun ways that advisors and can can work with you to make sure you're protected across the board, you know, in any of those capacities. And one piece of advice I would give you is, you know, if you're negotiating when you get to the, you know, final portion, you've gone through the QV, you have a buttoned up working capital, you know, your debt like items are have your accounting advisor also look at the purchase agreement because even if that means they only look at the accounting and finance definitions, right? Look at how

indebtedness cash working capital in the purchase price are determined and then look at the flow of funds. And those are, I would say, you know, most clients do a pretty good job of passing along to us, but some don't. And, you know, we always offer, hey, we're, we're happy to do it. And some of them like, no, we have an in-house team that does it. But I found that that's an area that a lot of buyers think that the transaction attorney is deeply involved in and quote, they've got it. But I found that on the accounting definitions portion, the transaction attorney typically doesn't have a CPA or doesn't have that background. And they they're not deep in what our QV working capital and debt actually looked like in the schedules we provided. So oftentimes the negotiated legal terms do not match the data book that we provided on indebtedness working capital and quality of earnings. Quality of earnings usually does because it's usually a multiple off of an EBITDA number, right? But debt and

working capital, you often go in there and you're like, hey, we excluded this and we put it in debt. You guys still have that working capital. Like, let's say you've treated deferred revenue as debt and like you go in deferred revenue is still defined within working capital because that's quote, every deal does it. And that's how the transaction attorney just put it in. But those are areas where I think value, you get down to the fifth yard line in value can be lost because you had a great provider doing all these things up to the point. But if it doesn't get in the legal document, it doesn't mean anything. Yeah, it doesn't matter. That is so good. And that's exactly why like one of the biggest pieces of advice is, you know, not just build your deal team, but build your deal team with people who are used to working with each other. Because for that very reason, because, you know, your accountant is not a lawyer and your lawyer is not an accountant and they need to be on the same page with the terms that they're using. So that what is reflected in the purchase agreement reflects what you did in the Q of E and what you've actually agreed to with

the flow of money. And you're exactly right. I mean, if if you're Q of E provider and your attorney are not on the same page, they could simply be identifying those those terms like what is actually included in working capital, what is included in accounts receivable. And if they don't use the words right, then those words mean something completely different in the purchase agreement. And that's how you can miss out. And so man, that is such that's that is real tangible, like, example of why it's so important to make sure that your deal team knows each other and they're working together on your behalf, not just doing their side load piece. Right. Wow. Excellent. Awesome, Jonathan. Well, hey, I appreciate you sitting down with me and really kind of walking through the fundamentals of financial due diligence. And how, you know, first time buyers, the things you should be looking for and how we can be better prepared. Going forward, if someone wants to work with you, you know, for either financial due due diligence, they have questions about Q of E, how can they get in touch with

you? Yeah. Yeah. So, you know, you can always reach out on LinkedIn, Jonathan Hutchins at ascenty partners. You know, email is jhutchins@ascentypartners.com if you want to shoot me a note. You know, happy to give you my cell phone as well. If you drop me a note and you know, happy to pick up a call and discuss what I can do. But yeah, I mean, we've got a team of us, you know, there's all I'll give you just the snippet background. There's about 25 of us across the U.S. that do diligence. I'm one of the folks, a lot of us are kind of ex big four folks, you know, across a breadth of industries. So pretty much any industry you are looking to do outside of some really deep healthcare stuff, we can, we can provide you the expertise you need. But yeah, we'll be happy to assist in any capacity. And we do a full breadth from cash proofs all the way up to full blown, you know, deep report in Excel deliverables, you know, based upon the kind of the needs, whether it be an ETA buyer up to a sophisticated strategic or private equity. So, maybe to help. Awesome. Well, thanks so much, Jonathan. I know this

is going to be super helpful, especially to, you know, first time searchers really going to grasp it like, you know, not just the importance of the QV and financial diligence, but who they can talk to to get their questions answered. So thanks again, Jonathan. I really appreciate it. Yeah, I appreciate you having me on.