Quality of Earnings Reports: What Sellers Should Know Before a Buyer Orders One

What a quality of earnings report is

A QofE is an independent accounting review of how much the business earns on an ongoing basis. Most deals in the lower middle market are priced as a multiple of earnings. That earnings figure is usually adjusted EBITDA, which is earnings before interest, taxes, depreciation and amortization, plus add-backs. Add-backs are expenses on your books that a new owner will not carry, such as your personal vehicle or a one-time legal bill. For smaller owner-run businesses, the figure is usually seller's discretionary earnings, or SDE, which also adds back the owner's own pay.

The QofE takes your reported earnings, tests whether the revenue and expenses hold up and will recur, checks every add-back, and arrives at the number the accountants believe a buyer can count on going forward. If the multiple stays the same and that number comes in lower, the price comes down with it.

How it differs from an audit

An audit checks whether your financial statements follow accounting rules and are free of major errors for a past period. A QofE asks a different question: what will this business earn under a new owner? It goes further into the details an audit does not focus on, such as whether a big contract will renew, whether margins are holding, whether one month's revenue was pulled forward, and whether each add-back is backed by paper.

Most small and mid-sized private businesses have never been audited. That is normal and buyers expect it. It does mean the QofE is often the first time an outside accountant has gone through the books line by line.

What the accountants test

Revenue. They tie the revenue on your income statement to bank deposits, a step called a proof of cash, and check that sales are recorded in the period they were earned. They look at revenue by customer to see concentration, and by month to see trends and seasonality.

Add-backs. Every adjustment you made to arrive at adjusted EBITDA or SDE gets tested. An add-back with an invoice, a receipt or a clear record behind it usually survives. One without paper usually does not. Recurring costs labeled one-time, such as a "one-time" repair that happens every year, get reversed. Our post on add-backs goes through what holds up.

Expenses. They check whether costs are complete. A business where the owner does work a paid employee would otherwise do, or where rent is below market because the owner owns the building, may have its earnings adjusted down to reflect what a new owner will pay.

Working capital. They study how much cash, receivables and inventory the business needs month to month, which feeds directly into the working capital target in the purchase agreement.

Accounting method. Many small businesses keep books on a cash basis, recording income when the money arrives and expenses when they are paid. Buyers think in accrual terms, recording income when it is earned and expenses when they are incurred. The QofE converts the numbers, and the conversion can move earnings in either direction.

What the report looks like

Most QofE reports open with a short summary and a table often called the EBITDA bridge. It starts with the earnings you reported, then lists every adjustment the accountants made, up or down, with a short reason for each, and ends at their adjusted figure. It is the page buyers and lenders read first, and it is where you should start too.

After that come sections on revenue and margins, customer concentration, working capital by month, and debt-like items. Debt-like items are obligations that are not loans but that a buyer treats like debt and subtracts from the price. Common ones are customer deposits for work not yet done, accrued but unpaid bonuses or vacation, unpaid taxes, and deferred revenue, which is money customers have paid for services you still owe them. Sellers are often surprised by this section, because these items never show up as debt on their own statements.

The review itself usually runs a few weeks during diligence, and the accountants will send a long list of questions and document requests. How fast you answer is part of how long it takes. A seller who has monthly statements, bank records and add-back support organized in one place gets through it faster and with fewer follow-up questions.

When the number comes down

It often does, at least a little. The question is by how much and why.

A small reduction from rejected add-backs or a timing adjustment is ordinary, and most buyers will close at the original price or close to it. A large reduction gives the buyer grounds to ask for a lower price or different terms, which is called a retrade. Sometimes the retrade is fair, because the QofE found a problem. Sometimes the buyer is using a modest finding to reopen a deal they wanted to reprice anyway.

Our job when a QofE comes back is to read it with you line by line, separate the solid findings from the arguable ones, and push back with documents where the accountants got it wrong. Many findings come down to a missing record that exists somewhere in your files.

How to prepare before a buyer orders one

Most of the preparation is the same work that makes a business easier to sell in the first place. Close the books every month instead of once a year at tax time. Reconcile bank and credit card accounts monthly. Keep personal expenses out of the business, or keep a clean list of the ones that are in it, with receipts. Write down every add-back with the documents behind it. Make sure your tax returns and your internal financial statements tell the same story, or that you can explain the difference. Know your revenue by customer and by month.

We go through this in detail in Clean Books Sell Businesses.

Should you order your own first?

Sellers on larger deals increasingly commission their own report before going to market, called a sell-side QofE. The seller pays for it, and the buyer's accountants still do their own review. The benefit is that you find the problems first, fix what can be fixed, and set the asking price on a number that has already been tested. Buyers tend to move faster when a credible report is in the data room, the secure online folder where documents are shared, and retrades get harder to justify.

It is not right for every business. For a smaller owner-run company sold to an individual buyer, an SBA lender's review and a good set of books are usually enough. For a business priced on adjusted EBITDA and likely to draw private equity or larger company buyers, a sell-side QofE is often worth the cost. We help sellers decide based on the size of the business, the likely buyers and the state of the books, and we can point you to accounting firms that do this work.

This article shares our opinion and general information. It is not legal or tax advice. Always speak with a licensed attorney for legal advice, and a qualified tax professional for tax questions, before you act.