Quality of Earnings Report: Why Every Lower Middle Market Seller Should Commission One Before Going to Market

There is a conversation that happens in almost every $5M+ lower middle market transaction, usually about 30 days after the Letter of Intent is signed.

The buyer’s accountants have been through the financials. They have found three or four things that they are now calling “EBITDA adjustments”, add-backs that they are disputing, revenue recognition timing they want to reclassify, one-time items that look suspiciously recurring when you look at them across multiple years. The buyer’s revised EBITDA number is $200K lower than what the seller presented. At a 6x multiple, that is $1.2M off the purchase price, negotiated from a position of weakness because the seller is already 30 days into exclusivity with one buyer and has no leverage to walk away.

This is the Quality of Earnings problem. And it is almost entirely preventable.

A Quality of Earnings (QoE) report is an independent accounting analysis of a business’s financial statements, performed by a CPA firm, that validates the sustainability and accuracy of reported earnings, identifies legitimate add-backs, normalizes EBITDA, and surfaces financial risks before buyers discover them. Sell-side QoE reports cost $25K-$50K. They routinely produce $500K-$2M+ in additional sale proceeds by bulletproofing the seller’s financial presentation before going to market. Sellers who skip them frequently lose that amount in late-stage deal renegotiation.

Key Takeaways

A Quality of Earnings report is an independent CPA analysis of the accuracy and sustainability of a business’s reported earnings.
Sell-side QoE (commissioned by the seller before going to market) costs $25K-$50K and typically generates a 10-40x return through better deal outcomes.
Buy-side QoE (commissioned by the buyer during due diligence) is standard practice for PE buyers on any deal above $5M in enterprise value.
The main risk of skipping a sell-side QoE: buyers discover financial issues during their own QoE and use them as leverage for late-stage price reductions with the seller locked in exclusivity.
Sellers who commission a sell-side QoE present more credibly to buyers, move through due diligence faster, and have fewer surprises at closing.

What a Quality of Earnings Report Actually Covers

A QoE report is not the same as an audit. An audit verifies that financial statements comply with GAAP. A QoE goes deeper, it evaluates whether the financial statements accurately represent the economic reality of the business and whether reported earnings are sustainable going forward.

The core deliverables of a lower middle market QoE report:

Adjusted EBITDA bridge. Starting from reported net income, the QoE documents and defends every add-back, owner compensation adjustments, one-time items, non-recurring expenses, creating an adjusted EBITDA figure that is documented, sourced, and defensible to any buyer’s accountant. This is the number that buyers apply the multiple to. A well-defended adjusted EBITDA is worth more than the same number presented without documentation.

Revenue quality analysis. Buyers care about whether revenue is sustainable, recurring, and growing. The QoE examines revenue by customer, by product or service line, by revenue type (recurring vs transactional), and identifies any concentration, seasonal patterns, or trends that could affect the business going forward.

Working capital analysis. Almost every M&A transaction includes a working capital adjustment at closing. The QoE establishes the historical average working capital of the business, which becomes the baseline for the working capital peg in the purchase agreement. Without this documentation, working capital negotiations at closing are adversarial and unpredictable.

Customer and revenue concentration. The QoE identifies any customer or revenue dependencies that could be characterized as concentration risk, allowing the seller to address them proactively in the narrative rather than having buyers surface them as problems.

Identification of financial risks. Pending liabilities, contingent obligations, insurance gaps, tax exposures, the QoE surfaces issues that would otherwise be discovered during buy-side due diligence, creating time for the seller to address or contextualize them before buyers use them as negotiating leverage.

Sell-Side vs Buy-Side QoE: The Critical Difference

A buy-side QoE is commissioned by the buyer after the LOI is signed. It is standard practice for any PE firm doing a lower middle market acquisition, and it is the primary due diligence tool that buyers use to validate EBITDA before finalizing deal terms.

The problem: by the time the buy-side QoE is underway, the seller is in exclusivity. They cannot market the business to other buyers. They have invested 30-90 days in the process. The transaction costs, legal fees, advisor time, management distraction, are already accumulating. When the buy-side QoE surfaces issues that reduce the EBITDA number, the seller has almost no leverage to push back.

A sell-side QoE changes this dynamic entirely.

By commissioning a QoE before going to market, the seller knows exactly what their EBITDA is, what add-backs are defensible, and what issues exist, before buyers have any leverage. The financial presentation is bulletproofed. Buyers who receive a sell-side QoE report with the CIM (Confidential Information Memorandum) conduct their own QoE faster and with less conflict because the major questions are already answered. The process moves faster, the deal is more certain, and late-stage renegotiation is far less common.

For businesses with $5M+ in enterprise value going to PE buyers, a sell-side QoE is not optional in today’s market, it is a competitive process tool.

The Math: Why $25K-$50K Always Makes Sense

A straightforward example. A business presents $1.8M in adjusted EBITDA without a sell-side QoE. During buy-side due diligence, the buyer’s accountants dispute $150K in add-backs as non-recurring items that look recurring, and flag another $80K in revenue recognition timing they want to reclassify. Their revised EBITDA: $1.57M.

At a 6x multiple, the gap between $1.8M and $1.57M is $1.38M in enterprise value. The seller, already 45 days into exclusivity, negotiates and settles at $1.65M EBITDA, a $150K reduction from the original. At 6x, that is $900K off the purchase price.

A sell-side QoE at $40K would have identified both of those issues before going to market, given the seller time to either address them or build a credible defense of why the add-backs are legitimate. The $900K renegotiation risk is eliminated. The $40K cost is 4.4% of the risk it eliminates.

When to Commission a QoE

The right timing for a sell-side QoE is 3-6 months before going to market, enough time to complete the report, address any issues it surfaces, and incorporate the findings into the CIM and financial presentation.

Commissioning a QoE after you are already in a process is less effective. The report can still help identify and defend add-backs, but the seller loses the primary benefit: controlling the narrative before buyers have seen the numbers.

For businesses under $5M in enterprise value with simple financials, a full QoE may be more than necessary. A thorough financial review by a CPA with M&A experience, less expensive than a full QoE, can produce similar benefits at lower cost.

Frequently Asked Questions

What is a Quality of Earnings report?

A Quality of Earnings report is an independent CPA analysis of a business’s financial statements that validates the sustainability of earnings, documents add-backs to adjusted EBITDA, and surfaces financial risks before buyers discover them during due diligence.

How much does a Quality of Earnings report cost?

For lower middle market businesses ($5M-$50M in enterprise value), sell-side QoE reports typically cost $25K-$50K depending on business complexity. They routinely return 10-40x that cost through better deal pricing and reduced late-stage renegotiation.

Do I need a QoE to sell my business?

Technically no, but for businesses above $5M in enterprise value going to PE buyers, it is strongly recommended. PE buyers will commission their own QoE during due diligence. Having a sell-side QoE ready addresses the major questions in advance, protects your EBITDA presentation, and reduces deal risk significantly.

What is the difference between a QoE and an audit?

An audit verifies that financial statements comply with GAAP. A QoE evaluates whether financial statements accurately represent the economic reality of the business and whether reported earnings are sustainable going forward, a different and more deal-specific question.

When should I commission a Quality of Earnings report?

3-6 months before going to market, so there is time to address any issues it surfaces and incorporate the findings into your financial presentation. Commissioning a QoE after you are already in a buyer process is less effective.

Daniel Askew is the Founder and CEO of Icon Business Advisors, a Nashville, Tennessee M&A advisory firm.

[Talk to an M&A Advisor], If you are preparing to go to market, understanding your QoE timing is one of the first conversations worth having.