Quality of earnings: what gets cut, what stays
There is a moment in almost every sale process where the EBITDA number the owner has been quoting stops being a number the owner controls. That moment is called Quality of Earnings. More deals get repriced, restructured, or quietly killed at this step than at any other point in the process. Almost none of those repricings have to happen.
Quality of Earnings, usually shortened to Q-of-E, is a third-party accounting investigation that a buyer commissions after a letter of intent is signed but before the deal closes. Its job is simple and uncomfortable: validate that the EBITDA the owner reported is actually the EBITDA that will exist after the sale. Anything that does not survive that test gets removed.
Most owners encounter Q-of-E for the first time during their own deal, and most of the surprises are bad. The surprises are almost entirely preventable.
What Q-of-E actually is
A Q-of-E engagement is run by an accounting firm hired by the buyer. The firm spends three to six weeks inside your financials, looking at every adjustment the owner has claimed (the "add-backs") and every category of revenue and expense that affects normalized cash flow.
Their output is a Quality of Earnings Report, usually 40 to 100 pages, that contains an adjusted EBITDA figure. That figure becomes the new center of gravity for the rest of the deal. If it lands close to what the buyer expected, the deal closes on the original terms. If it lands meaningfully below, the buyer has three choices: walk away, retrade the price, or change the structure (more earnout, more rollover, lower cash at closing). They almost always choose option two or three.
The buyer's accounting firm is not adversarial. They are professional. They are also extremely thorough, and the burden of proof for any number that increases EBITDA sits squarely on you.
What gets cut, what stays
The patterns are remarkably consistent across deals. Below is the short list of the categories that come up in almost every Q-of-E.
Usually cut
- Owner perks not formally documented (cars, club memberships, personal travel, family meals coded as business)
- Family members on payroll without a defined role
- Owner compensation above-market only to the extent the buyer can prove a market rate
- Revenue recognized too early, particularly on multi-year contracts
- Recurring expenses re-labeled as "one-time"
- Inventory write-ups, deferred maintenance, or under-funded reserves
- Cash-basis revenue mixed with accrual-basis expense (or vice versa)
Usually kept
- Genuinely non-recurring legal or settlement costs, with documentation
- One-time professional fees clearly tied to a defined project
- Severance or one-time recruiting costs that will not repeat
- Documented insurance claims, weather events, or supply-shock losses
- Owner salary that the buyer will not have to replace post-close (above and beyond market replacement)
- Departed product lines or customers shown clean on a separated basis
- One-time technology investments fully implemented before the trailing twelve months
The line between "kept" and "cut" almost always comes down to documentation. An add-back that is supported by a contract, an invoice, a paid-in-full receipt, and a memo describing why it will not recur typically survives. The same dollar amount supported only by the owner's recollection typically does not.
The five categories where most of the money is lost
1. Undocumented owner perks
The line item that disappears most often is also the one owners are least willing to give up. Cars, club memberships, family travel, personal phone bills, family on payroll without a role. None of these are illegal. All of them are personal expenses that a new owner will not actually have to pay. The Q-of-E firm strips them out because they want a number that matches the buyer's post-close operating cost.
2. Owner compensation
Most owners pay themselves either too much or too little, and Q-of-E adjusts to a market rate for the role. If you pay yourself 600,000 dollars as CEO and the market rate for a CEO of a business your size is 350,000, the Q-of-E firm will only add back 250,000. If you pay yourself 100,000 to keep your taxable income down, the firm will subtract roughly 250,000 from EBITDA to fund the rate the buyer will have to pay your replacement.
3. "One-time" expenses that are not actually one-time
Owners often label any expense above their expected baseline as "one-time." A Q-of-E firm asks a different question: would a sensible new owner expect to incur this kind of expense again over the next several years? If the answer is yes (legal fees, IT spend, marketing, recruiting), the add-back gets reversed.
4. Revenue timing
This is the deepest minefield. If you sell annual contracts and recognize the full first month's invoice in the first month, your trailing twelve months looks better than the buyer's first twelve months will. The Q-of-E firm will straighten the recognition curve to reflect what a clean accrual-basis income statement should show, and the timing differences usually go against the seller.
5. Working capital normalization
Q-of-E also sets the working capital target that becomes the closing peg. A seller's natural impulse before a sale is to harvest cash and slow down payables. A Q-of-E firm will look at the trailing twelve to twenty-four months and set a "normal" working capital level that the seller must hand over at closing. Aggressive cash management before a sale almost always shows up as a working capital shortfall at closing, dollar for dollar.
The single biggest preventive tool
The single most effective thing a sell-side owner can do is commission their own Q-of-E before going to market. Sellers call this a "sell-side Q-of-E" or a "quality of earnings prep." It costs 25,000 to 100,000 dollars depending on the size of the business, and it returns most of that several times over on close to every deal.
A sell-side Q-of-E does three things. First, it surfaces every add-back that will be cut so you can decide before negotiations whether to take it off the table voluntarily or document it well enough to defend it. Second, it gives the buyer's diligence firm a head start that compresses the buy-side process from six weeks to two or three. Third, and most importantly, it removes the seller's biggest source of leverage loss: the surprise.
What to do this quarter
If you are 12 to 24 months from a possible sale, the work is on the books and the documentation, not on the operating business itself. Five steps, all completable in a quarter.
- Close your books monthly on an accrual basis. If you are still running cash-basis at the close-the-books level, change that now. Buyers expect accrual.
- Run an add-back review. List every adjustment you would expect to add back to EBITDA. For each one, write the supporting documentation you have (invoice, contract, memo). If you cannot point to documentation, the add-back is at risk.
- Right-size owner comp on paper. Get a market-rate study for your role. Adjust your stated compensation to that rate in your normalized model. Do not change actual payments; just clean the model.
- Document any one-time event. Settlements, departures, casualty losses, COVID-era anomalies. Anything you want to add back should have a single-page memo on file describing what happened, when, and why it will not recur.
- Have a conversation with your CPA about a sell-side Q-of-E in the 12 months before going to market. Most CPAs do not run them. Most M&A advisors know which Q-of-E firms in your market are best fit for your size of business.
None of this work is glamorous. The owners who do it consistently land the price they expected, and the owners who do not consistently land 10 to 25 percent lower. The math is unforgiving and known.
Sources: Practitioner synthesis of standard lower-middle-market quality-of-earnings procedures as performed by national and regional accounting firms. Cross-checked against Exit Planning Institute curriculum and Christopher Snider, Walking to Destiny (Exit Planning Institute, 2016). Examples and commentary are the work of the Next Chapter Wealth editorial team.