If you're preparing to sell your business, you'll inevitably encounter the term “Quality of Earnings” or “QoE.” This financial analysis has become a standard part of the M&A due diligence process, and understanding it is critical for any founder looking to maximize their exit value.
What Is a Quality of Earnings Analysis?
A Quality of Earnings analysis is a detailed examination of your company's financial statements, typically performed by an accounting firm hired by the buyer. Its purpose is to validate your reported earnings and assess the sustainability and quality of your cash flows.
Unlike a standard audit, which focuses on whether your financials comply with accounting standards, a QoE analysis digs deeper. It asks: “Are these earnings real, repeatable, and representative of the business going forward?”
Key Insight
Think of a QoE as a financial stress test. The buyer wants to understand not just what your earnings were, but what they're likely to be under their ownership.
Why It Matters to Sellers
The QoE analysis often determines whether a deal closes at the agreed-upon price—or at all. Here's why it matters:
Price Adjustments
QoE findings can lead to purchase price reductions if earnings are lower than represented.
Deal Structure
Issues discovered may result in earnouts, escrows, or other risk-shifting mechanisms.
Buyer Confidence
A clean QoE builds trust; a messy one creates doubt and invites renegotiation.
Timeline Impact
Problems in QoE extend diligence and can cause deals to fall apart.
What Buyers Look For
During a QoE analysis, buyers and their advisors are trying to answer several key questions:
- Earnings sustainability: Are the profits recurring, or driven by one-time events?
- Revenue quality: How sticky is the revenue? What's the customer concentration?
- Working capital: What level of working capital is needed to run the business?
- Normalization: What expenses are personal or non-recurring that should be added back?
- Accounting practices: Are revenue and expenses recognized appropriately?
Common EBITDA Adjustments
EBITDA adjustments—or “add-backs”—are a critical part of the QoE process. These adjustments normalize earnings to reflect the true economic performance of the business.
| Adjustment Type | Example | Buyer Perception |
|---|---|---|
| Owner compensation | Above/below market salary | Generally accepted |
| One-time expenses | Lawsuit settlement, relocation | Accepted with documentation |
| Personal expenses | Owner's car, travel, family payroll | Scrutinized heavily |
| Pro forma adjustments | Full-year impact of new contract | Often discounted or rejected |
Red Flags That Kill Deals
Certain findings in a QoE analysis can derail a transaction. Here are the issues that make buyers nervous:
Deal Killers to Avoid
- Significant unexplained discrepancies between reported and adjusted EBITDA
- Aggressive revenue recognition (booking revenue before it's earned)
- Customer concentration above 25% with no contracts
- Declining revenue trends masked by add-backs
- Related-party transactions that obscure true economics
- Poor documentation or inability to support adjustments
How to Prepare for a QoE Analysis
The best time to prepare for a QoE is before you go to market. Here's how to get ready:
Get your financials in order
Ensure your books are clean, reconciled, and up-to-date. Consider a reviewed or audited financial statement.
Document your add-backs
Create a detailed schedule of every adjustment with supporting documentation. If you can't prove it, don't claim it.
Conduct a sell-side QoE
Consider hiring your own accounting firm to perform a QoE before going to market. This identifies issues early.
Prepare a working capital analysis
Understand your normalized working capital needs. This will be a negotiation point.
Organize your data room
Have contracts, customer lists, vendor agreements, and other supporting documents ready and organized.
Key Takeaways
- A QoE analysis validates your earnings and is standard in M&A transactions
- Findings directly impact purchase price and deal structure
- Prepare early—ideally 12-18 months before going to market
- Document everything; unsupported add-backs will be rejected
- Consider a sell-side QoE to identify issues before buyers do
- Work with experienced M&A advisors who understand the process
Dan Doran, CVA
Founder, Quantive
Dan is a Certified Valuation Analyst and M&A advisor with over 20 years of experience helping founders navigate successful exits. He's completed hundreds of valuations and advised on transactions across technology, business services, and healthcare.
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