Key Takeaways
- A QofE is not an audit. It is a focused analysis of whether the seller's EBITDA is real, recurring, and achievable under new ownership. It often changes the purchase price or the APA terms after it is complete.
- Add-backs are the contested core of every QofE. The seller's list is always more aggressive than the buyer's. Understanding which add-backs are defensible before signing the LOI prevents a renegotiation fight at the worst possible moment.
- Working capital peg disputes are one of the most common post-close financial arguments. Setting the peg correctly in the APA, based on QofE findings, is worth the upfront time even on smaller deals.
- QofE findings feed directly into APA representations. Issues discovered during QofE that the seller discloses in the disclosure schedules become known risks the buyer accepts at closing, not post-closing indemnification claims.
Most small business acquisitions are priced as a multiple of EBITDA. Sellers present trailing twelve-month earnings, buyers apply a multiple, and both parties sign an LOI around that number. The problem is that seller-stated EBITDA in small business deals is rarely the same number a buyer's accountant would calculate using the same financial records.
Owner-operators run personal expenses through the business. They pay themselves above or below market. They defer capex and inflate current-year earnings. They have one-time items that look recurring to an outside observer, and recurring costs they characterize as one-time. A quality of earnings analysis examines these issues systematically and produces an adjusted EBITDA number that reflects what the business will actually generate under new ownership. That number is what the buyer should pay a multiple on, not the seller's opening ask.
What a QofE Is, and What It Is Not
A quality of earnings report is an agreed-upon procedures engagement or advisory analysis performed by an accounting firm or financial advisory firm. It is not an audit. The QofE provider does not express an opinion on the financial statements and does not test every line item for GAAP compliance. Instead, it focuses on the questions most relevant to an acquirer: Is the reported EBITDA real? Is it recurring? Does it reflect what the business will earn under new ownership?
A QofE typically covers: three years of income statements with a trailing twelve-month bridge; revenue by customer, product line, and contract type; the seller's add-back schedule with analysis of each item; expense categorization and identification of unusual or non-recurring items; working capital analysis; and identification of off-balance-sheet obligations or contingent liabilities that affect normalized earnings.
QofE vs. Audit vs. CPA Review: What Each Provides
When a Buyer Under LOI Needs a QofE
Not every small business acquisition requires a full QofE. The decision depends on deal size, financial complexity, and how much of the purchase price is based on the seller's unverified EBITDA.
A QofE is generally worth the cost when: (1) total deal value exceeds $1.5 to $2 million; (2) the business has multiple revenue streams or significant customer concentration; (3) the seller's financials are internally prepared rather than CPA-compiled or reviewed; (4) the seller's add-backs exceed 20 percent of stated EBITDA; or (5) SBA lender underwriting requires validated earnings to support the debt service coverage calculation.
For very small deals under $1 million, a focused due diligence review by M&A counsel and a CPA examining the tax returns and bank statements can often identify the most significant issues without a formal QofE engagement. The relevant question is: what is the cost of getting this number wrong by 20 percent? On a $500,000 deal, the answer may not justify a $15,000 QofE. On a $3 million deal at 4x EBITDA, a 20 percent EBITDA adjustment is a $600,000 purchase price mistake.
Add-Backs: The Most Contested Part of Any QofE
Add-backs are adjustments to the reported earnings that increase stated EBITDA to reflect what the business would earn under new, efficient ownership. Sellers present add-back schedules with every listing. QofE providers evaluate whether each add-back is legitimate.
The add-backs that generate the least dispute are clear owner-specific items: above-market owner compensation, personal vehicle expenses, personal travel, owner health insurance, and other clearly personal expenses that will not be incurred by the buyer. These are universally accepted because the buyer will not spend those dollars.
The add-backs that generate the most dispute are items presented as one-time that the QofE provider identifies as recurring: legal fees (sellers characterize as dispute-specific but which recur every few years), equipment maintenance presented as emergency repairs, consulting fees paid to related parties, and marketing expenses the seller stopped spending when they decided to sell. If an expense appears in two of the last three years, it is likely recurring regardless of how the seller characterizes each instance.
Buyer caution: A seller's add-back schedule that inflates EBITDA by 30 percent or more relative to tax return income is a signal requiring detailed examination. Tax return income is harder to manipulate than internal P&L because it is filed with the IRS. A large gap between tax return income and seller-stated EBITDA, after legitimate add-backs, suggests either aggressive accounting or unreported revenue, both of which carry risk.
Working Capital and the Peg
Working capital is current assets minus current liabilities. At closing, the seller is expected to deliver the business with a normal level of working capital so the buyer can operate without an immediate infusion. The working capital peg is the agreed target level, and the purchase price adjusts based on actual working capital at close relative to the peg.
Setting the peg is a QofE output. The QofE provider analyzes trailing working capital over 12 or 24 months and identifies the average level, excluding seasonal swings and one-time items. That average becomes the peg. A peg set too low allows the seller to strip cash and receivables before closing. A peg set too high requires the seller to fund working capital above historical levels.
Working capital disputes are among the most common post-closing financial disputes in small business acquisitions. Sellers and buyers often disagree about what counts as a current liability (deferred revenue, customer deposits, accrued vacation), how to handle receivables that the seller disputes collecting, and whether the peg calculation should exclude one-time receivables or payables present at the measurement date. The APA's working capital definition, which should follow the QofE methodology, determines how these disputes are resolved.
How the QofE Feeds into the APA and Representations
The QofE findings directly affect how the APA is drafted. Issues identified during QofE that the seller acknowledges and discloses in the APA's disclosure schedules become known risks that the buyer is accepting at closing. A seller who discloses a contingent liability discovered during QofE in the disclosure schedules limits their post-closing indemnification exposure for that item. A seller who does not disclose it remains exposed to an indemnification claim.
This interaction between QofE findings and disclosure schedules is one of the reasons that M&A counsel should review the QofE report before the APA is finalized. Issues that appear in the QofE but are not addressed in the APA representations or disclosure schedules create gaps that favor whichever party notices them first. For the APA review process and how representations interact with diligence findings, see the asset purchase agreement review attorney page.
Buyers in SBA-financed acquisitions have an additional use for QofE findings: the lender's underwriting relies on normalized EBITDA to calculate debt service coverage. A QofE that reduces normalized EBITDA can affect the loan amount the SBA lender will approve, which may require renegotiation of the purchase price or the financing structure. For the full scope of SBA acquisition financing requirements, see the small business acquisition attorney page.
Under LOI and Working Through Due Diligence?
Acquisition Stars works with buyers from LOI through closing on small business acquisitions, including coordinating QofE findings with APA drafting and SBA lender requirements. Alex Lubyansky handles every engagement directly. If you are under LOI and need counsel for the due diligence and closing phase, submit your transaction details for an engagement assessment.
Frequently Asked Questions
What is a quality of earnings report?
A quality of earnings (QofE) report is an analysis performed by a financial advisory firm that examines whether the seller's reported EBITDA is reliable, recurring, and free of accounting errors or manipulation. It is not an audit. It focuses on normalizing the seller's financials by identifying non-recurring items, owner-specific expenses, and accounting anomalies that inflate or deflate reported earnings. The output is an adjusted EBITDA figure that reflects what the business will likely generate under new ownership, which is the number the buyer's purchase price should be based on.
Do I need a quality of earnings report for a small business acquisition?
Not always, but more often than buyers expect. For acquisitions over $2 million in deal value where EBITDA is the purchase price anchor, a QofE is generally worth the cost. For deals under $1 million with simple financials, a thorough review by M&A counsel and a CPA may be sufficient. The trigger question is: how much do you trust the seller's EBITDA number, and how much does a 20 percent adjustment to that number change whether you overpaid? If you are paying 4x EBITDA and a QofE reduces EBITDA by $100,000, the purchase price impact is $400,000.
What are add-backs in a quality of earnings analysis?
Add-backs are expenses that the QofE provider identifies as non-recurring or owner-specific and excludes from the normalized EBITDA calculation. Common add-backs include: owner compensation above a market-rate salary for the role the buyer will fill; personal expenses run through the business; one-time costs that will not recur (litigation settlement, one-time equipment repair); and discretionary expenses the new owner would not incur. The dispute in QofE analysis is almost always about which add-backs are legitimate. Sellers add back aggressively; buyers push back on anything that is recurring or that the buyer will need to incur.
What is a working capital peg and why does it matter?
A working capital peg is the agreed-upon target level of net working capital (current assets minus current liabilities) that the seller must deliver at closing. If the actual working capital at close is above the peg, the buyer pays the seller the excess. If it is below the peg, the seller refunds the shortfall. The peg prevents the seller from draining the business of cash and receivables before closing. It is typically set based on the average trailing working capital over 12 months. Getting the peg calculation right in the APA is one of the most practically significant outcomes of a QofE analysis.
How does a QofE interact with the purchase price?
The QofE adjusts the EBITDA number that the purchase price multiple is applied to. If the LOI is signed at 4x seller-stated EBITDA of $500,000, the implied price is $2 million. If the QofE identifies that $150,000 of that EBITDA is non-recurring, adjusted EBITDA is $350,000, implying a $1.4 million price at the same multiple. Whether that adjustment is negotiated down from the LOI price depends on how the LOI is written and what leverage the buyer has after the QofE is complete. LOIs that tie purchase price firmly to a stated number rather than to an EBITDA multiple give buyers less room to renegotiate on QofE findings.
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