Quality of Earnings, Explained: What Buyers Look For and How to Prepare

In almost every lower-middle-market acquisition, the price is a multiple of EBITDA. That makes the question "what is the real, repeatable EBITDA of this business?" the most important number in the deal. A quality-of-earnings review is how buyers, lenders and increasingly sellers answer it.

What a quality-of-earnings review is

A quality-of-earnings (QoE) review is a financial due-diligence analysis, usually performed by an accounting or advisory firm, that tests whether a company's reported earnings are accurate, sustainable and representative of what a new owner can expect. It produces an adjusted EBITDA figure and explains every adjustment that bridges reported results to that number.

It is not an audit. An audit gives an opinion on whether financial statements are presented fairly under accounting standards. A QoE asks a different question: setting aside one-time events and owner-specific items, what does this business earn on an ongoing basis, and how much cash does that turn into?

What a QoE typically covers

• Adjusted EBITDA for the trailing twelve months and prior years
• Revenue quality: recognition policies, recurring versus one-time revenue, customer concentration and churn
• Margin analysis by product, customer or channel
• Net working capital: what level is normal for the business, which becomes the target in the purchase agreement
• Proof of cash: tying reported revenue to bank deposits
• Debt and debt-like items that may reduce the price, such as deferred revenue, accrued bonuses or unpaid taxes
• Run-rate and pro forma items, such as a recent price increase or a new contract

The adjustments buyers scrutinize

Adjustments, often called add-backs, are where most disagreements happen. Buyers generally accept adjustments that are clearly non-recurring and well documented, and they push back on adjustments that look like optimism.

Usually accepted when documented

• Owner compensation above or below a market-rate replacement
• Personal expenses run through the company
• Truly one-time legal, consulting or transaction costs
• Related-party rent adjusted to market

Often challenged

• "One-time" costs that recur every year under different names
• Savings that have not happened yet
• Revenue from contracts not yet signed
• Removing costs that a new owner will actually need, such as a CFO the company has gone without

Buy-side versus sell-side QoE

A buy-side QoE is commissioned by the buyer, usually after a letter of intent is signed. A sell-side QoE is commissioned by the owner before going to market. A sell-side review costs money and time up front, but it lets you find and fix issues on your timeline, support your adjusted EBITDA with an independent analysis, and reduce the chance of a price renegotiation late in the process. Buyers will typically still perform their own work, but a credible sell-side report tends to narrow the debate.

Industry nuances: insurance and warranty businesses

For managing general agents, warranty administrators and protection-plan companies, QoE work goes beyond standard add-backs. Expect careful review of revenue recognition on multi-year contracts, unearned revenue and reserves, claims development, commission and profit-sharing arrangements with carriers, and how much of the earnings depend on a single program or capacity provider. See our article on M&A considerations for insurance and warranty businesses.

How to prepare

1. Close the books monthly and reconcile balance sheet accounts every month.
2. Build a schedule of every proposed adjustment with the invoice, contract or payroll record that supports it.
3. Separate personal and business expenses going forward, well before a sale.
4. Document revenue recognition policies, especially for multi-period contracts.
5. Track monthly working capital so you can show what is normal and what is seasonal.
6. Have your outside CPA review the year-end numbers, or move to a review or audit if lenders or buyers will expect it.