Client Profile
A private equity firm offering strategic capital along with advisory services to middle-market businesses across a range of industries.
Target Business
A management consulting firm specializing in IT and computer systems implementation for private equity sponsors and their portfolio companies.
Situation
Our engagement was to perform a Quality of Earnings review in support of the Client’s potential financing arrangement with the Target. During the course of the engagement, several complexities emerged:
- Inconsistent Reporting Periods: The Target recorded revenue and cost of services using a 4-4-5 calendar structure, while all other general ledger accounts were maintained using a traditional month-end close. This misalignment created timing differences and limited the comparability of historical results.
- Non-Recurring, Project-Based Revenue: The Target’s business model was driven by discrete consulting projects that were largely non-recurring in nature. As such, past performance offered limited predictability regarding future earnings.
Solution
We implemented several targeted analyses to normalize performance, assess sustainability, and highlight areas of risk:
- Customer Concentration Risk: Identified a high reliance on a limited number of key customers. Recommendation that the Client evaluate the impact of potential revenue loss alongside a review of the existing project pipeline to assess future revenue visibility.
- Revenue Timing Adjustments: Adjusted EBITDA upward to reflect historical sales adjustments recorded outside the appropriate revenue periods. Additionally, timing differences created by the use of a 4-4-5 calendar were normalized to align reported gross profit with true monthly performance.
- Bad Debt and Allowance Adjustments: EBITDA was adjusted downward for material changes in the allowance for doubtful accounts methodology and identified bad debt expense attributable to specific customers, providing a more accurate reflection of recurring profitability.
- Contractor Classification Risk: Determined that a majority of the Target’s key project managers—classified as 1099 contractors—functioned in a capacity consistent with W-2 employment under IRS guidelines. Recommendation that the Client assess the potential legal, tax, and financial implications of reclassification and develop a mitigation plan as part of post-close planning.
Outcome & Impact
The analysis delivered critical insight into the true earnings capacity and operational risks of the Target:
- Provided a clear, adjusted view of the business’s historical financial performance.
- Highlighted revenue volatility and dependency on project flow.
- Identified potential compliance and tax exposure tied to contractor misclassification.
- Equipped the Client with data-driven recommendations for valuation, deal structure, and post-close integration planning.
Value Delivered
- Delivered a normalized quality of earnings report that accounted for calendar inconsistencies and project-based timing nuances.
- Provided financial clarity that allowed the Client to confidently assess the sustainability of earnings and plan for future staffing and compliance issues.
- Informed legal and financial diligence strategies by identifying operational red flags, including revenue concentration and contractor classification.
