Quality of Earnings: A Seller's Guide to QofE
What a quality of earnings report is, who commissions it, what it costs, which add-backs survive it, and how a seller prepares so the review confirms the price rather than reopening it.
The review that decides whether the earnings figure in your offer survives to closing. What it examines, which adjustments hold, and how owners prepare for it before a buyer is ever approached.
What is a quality of earnings report?
independent accounting review that tests whether a company's reported profit is a reliable guide to its future cash earnings
. It is commissioned during diligence, almost always by the buyer, and it is the single most common reason a price agreed in a letter of intent changes before closing.
A QofE is not an audit. An audit asks whether the financial statements comply with the accounting rules. A QofE asks a narrower and more commercial question: if I buy this business, what will it actually earn for me, and which parts of the reported number will not repeat. The output is an adjusted EBITDA figure, a list of every adjustment supporting it, and a set of findings on working capital, revenue recognition and customer concentration.
Typical timing", value: "After the letter of intent is signed
Primary output", value: "Adjusted EBITDA and a net working capital target
The order below is roughly the order a diligence team works in. Each stage can move the earnings figure, and the earlier stages move it most.
Proof of revenue: Reported revenue is traced from the accounting system to invoices, to contracts, and then to cash received in the bank. Where those three do not agree, the lowest supportable figure tends to win. Businesses that bill from a field service system and keep the books somewhere else are the ones most often surprised here.
Reported revenue is traced from the accounting system to invoices, to contracts, and then to cash received in the bank. Where those three do not agree, the lowest supportable figure tends to win. Businesses that bill from a field service system and keep the books somewhere else are the ones most often surprised here.
Whether revenue was recorded in the period it was earned. Deposits taken in advance, multi-month maintenance agreements billed annually, and work in progress at a period end all get restated onto the correct basis, which can move a strong-looking year into a weaker one.
Owner compensation is restated to what it would cost to hire a market-rate manager. Related-party rent is restated to market. Costs the buyer will still carry, but which the seller has been running through the company informally, come back into the earnings figure.
Testing every add-back: Each proposed adjustment is tested individually for whether it is genuinely non-recurring and whether it is documented. An add-back with an invoice, a board minute or a settlement agreement behind it usually survives. One supported only by an explanation usually does not.
Each proposed adjustment is tested individually for whether it is genuinely non-recurring and whether it is documented. An add-back with an invoice, a board minute or a settlement agreement behind it usually survives. One supported only by an explanation usually does not.
Run-rate and pro forma adjustments
Contracts won or lost during the period are annualized, so a customer gained in month ten is reflected for a full year and one lost in month four is removed. This cuts both ways, and it is the area where a well-prepared seller can add earnings rather than lose them.
A monthly working capital history is built to set the target level the business must be delivered with at closing. This is a separate negotiation from price, it is frequently overlooked by sellers, and on a lower middle market deal it can be worth more than several tenths of a turn on the multiple.
Customer, contract and concentration testing
Revenue by customer over several years, contract terms, renewal and churn rates. Concentration does not usually remove earnings, but it changes the multiple applied to them and it often changes the deal structure toward an earn-out.
Holds, up to the difference between what the owner is paid and what a replacement manager would cost. The replacement figure has to be defensible, and a buyer will use a real market rate rather than a nominal one.
Genuinely one-off legal or settlement costs
Holds where there is a settlement agreement or a closed matter behind it. A business with a legal cost line in every one of the last five years does not have a one-off legal cost.
Personal expenses run through the company
Holds when documented item by item: the vehicle, the phone, the travel, the family member on payroll who does not work in the business. Presented as a single round-number adjustment, it is usually removed.
Holds for a specific project such as a system implementation or a one-time restructuring. Does not hold for the accountancy fees the business will keep incurring every year.
Rent above or below market to a related party
Holds in both directions, restated to a market rent. Owners who charge themselves below-market rent and forget to adjust are giving away earnings they are entitled to.
Does not hold as an add-back, and often works against you. A fleet or plant that has not been replaced on a normal cycle becomes a capital expenditure finding, and buyers price it.
Does not hold. Any government relief in the historical numbers is removed, because it will not recur for the buyer.
Projected savings the buyer will make
Does not hold. Synergies belong to the buyer and are never paid for in the seller's earnings figure, however obvious they look.
Accounting records reconcile to the tax returns and to the bank, without explanation
Every add-back already has its supporting document attached
Revenue split into recurring, repeat and project, with margin shown on each
A monthly working capital history is available for the last three years
Contract wins and losses are already annualized in the numbers presented
Customer concentration was disclosed in the memorandum, not discovered in the review
The seller commissioned their own review before going to market
Earnings presented from management accounts that do not tie to the filed returns
A large round-number add-back described as owner discretionary expenses
Revenue recognized when invoiced on contracts that run for a year
No working capital history, so the target is set from the buyer's analysis alone
Personal expenses mixed into cost lines with no itemization
A customer representing a large share of revenue that first appears in week four
Relief income or a one-off large project left in the trailing earnings figure
A seller can commission their own review before going to market. It is optional, it costs money, and on a larger or more complex business it is usually worth it. These are the parameters we see rather than a quotation.
Who performs it: An independent accounting or transaction advisory firm
When a seller would do it
Before approaching buyers, not after a letter of intent
Period covered: Trailing twelve months plus two to three prior years
Elapsed time: 3 to 6 weeks, longer where records need rebuilding
What it produces: Adjusted EBITDA, a documented add-back schedule, a working capital target
Main benefit: Findings are fixed before a buyer sees them, not negotiated after a price is agreed
Main cost: A fee paid up front with no guarantee a sale follows
The value of a seller-side review is not that it flatters the numbers. It is that it removes the buyer's opportunity to reprice you in week twenty with a finding you could have resolved in week two. Where the records are already clean and the business is straightforward, the same benefit can often be achieved by preparing the add-back schedule and reconciliations properly and skipping the formal report.
Who pays for the quality of earnings report?
In almost every lower middle market transaction the buyer commissions and pays for the diligence review, because it is their capital at risk and they need an independent view. A seller can commission a separate review of their own before going to market, at their own cost, to find and fix the issues first. The two are different exercises with different audiences, and a buyer will not simply accept a seller's report in place of their own.
How is a quality of earnings report different from an audit?
An audit tests whether historical financial statements are presented fairly under the applicable accounting standards. A quality of earnings review tests whether the earnings a buyer is being asked to pay a multiple of are sustainable and repeatable. An audited business can still have a difficult review, because audited profit and adjusted EBITDA are answering different questions.
How long does the review take?
Three to six weeks is typical once the data room is populated. The variable is not the diligence team's speed, it is how quickly the seller can produce reconciliations, contracts and supporting documents. Businesses that have to rebuild three years of records while the review is running are the ones where the process runs to eight weeks or more, and delay itself costs deals.
Can the review reduce the price after a letter of intent is signed?
Yes. A letter of intent is normally non-binding on price and states an offer based on a stated earnings figure. If the review concludes that the figure is lower, the buyer will usually seek to apply the agreed multiple to the revised number. That is precisely why the earnings presented at the outset should be the earnings you can prove, rather than the most flattering ones available.
What is net working capital and why does it come up here?
Net working capital is the receivables, inventory and payables the business needs to keep operating. Buyers expect to receive the business with a normal level of it, and the review sets that normal level from your own monthly history. If you are delivered below the target, the purchase price is adjusted down at closing. Sellers who have never seen a monthly working capital schedule for their own business are at a disadvantage in that negotiation.
Should I commission a review before I go to market?
It depends on size and complexity. For a business with clean records, one revenue stream and a straightforward cost base, preparing a documented add-back schedule and proper reconciliations achieves most of the benefit at a fraction of the cost. For a business with multiple entities, related-party arrangements, mixed contract and project revenue, or records that do not reconcile easily, the review usually pays for itself in price protection.
What should I do first?", answer:
Find out what the business is likely to be worth and which factors are suppressing that number, because several of them take twelve to twenty-four months to fix and are worth far more than anything achievable in negotiation. The free written valuation report rebuilds your earnings the way a buyer will, and it commits you to nothing.
Selling a Business in the US
How a quality of earnings review is conducted in a lower middle market US transaction, which adjustments survive it, and how sellers prepare for it.
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