What a Quality of Earnings Report Reveals Before a $1M to $20M Acquisition
You have signed the letter of intent. The valuation looked reasonable, built off a multiple of last year’s EBITDA. Then the buyer’s accountants start asking for bank statements, and the number begins to move.
That process is a quality of earnings analysis, and it decides more deals in the lower middle market than any legal issue ever will.
Most due diligence content focuses on legal red flags: unassigned intellectual property, missing corporate records, problematic contracts. Those matter, and we write about them often. But the financial diligence artifact is separate; it arrives earlier, and it usually determines the price you actually receive.
Here is what a quality of earnings report examines, what it tends to find in companies this size, and how to prepare before a buyer’s team arrives.
What a Quality of Earnings Report Actually Is
A quality of earnings report, commonly shortened to QofE, is an independent analysis of whether a company’s reported profit reflects the real, repeatable economics of the business.
Note the word repeatable. Buyers are not paying for last year. They are paying a multiple based on what the business will produce going forward, so the analysis asks which earnings will continue after closing and which will not.
A QofE is not an audit
This distinction confuses sellers constantly, so it is worth stating plainly.
An audit tests whether financial statements comply with accounting standards. It looks backward and it certifies. A QofE asks a different question entirely: are these earnings real, and are they sustainable?
An audited company can still receive a rough QofE. Compliance with GAAP does not mean the reported EBITDA reflects what a new owner will actually earn.
Who commissions it
Buyers typically commission a buy-side QofE after signing the letter of intent. Their accounting firm performs it, and the buyer pays for it.
Sellers can commission their own, called a sell-side QofE, before going to market. More on that later, because it is the single most useful preparation step available to a seller at this size.
Why it matters most in your range
Companies between $1M and $20M often lack audited financials, use cash-basis or hybrid accounting, and blend owner personal expenses into the business. None of that is unusual, and none of it is disqualifying.
It does mean the gap between reported profit and true economic profit tends to be wider here than in larger deals. The QofE exists to measure that gap.
What the Report Digs Into
The scope varies by deal size and industry. A few areas appear in nearly every engagement.
Proof of cash
Analysts tie reported revenue to actual bank deposits, month by month. Sounds basic, and it catches real problems.
Revenue recorded but never collected shows up here. So do deposits that never made it into the books. Any meaningful gap between the two triggers deeper work.
Revenue recognition
The question is timing. Was revenue recorded when earned, or when invoiced, or when the cash arrived?
Businesses with deposits, retainers, subscriptions, or long project cycles frequently record revenue earlier than they should. That inflates the recent period and makes growth look stronger than it is.
Deferred revenue gets special attention. If customers have prepaid for services not yet delivered, the buyer inherits that obligation, and it affects both the earnings picture and the closing balance sheet.
Customer concentration
Analysts break revenue down by customer and track it across three years.
A company earning 40% of revenue from one client is a different asset than one with two hundred customers, even at identical EBITDA. Concentration usually costs the seller in multiple, in escrow terms, or both.
Margin and expense trends
Reviewers look for margins that improved suspiciously right before the sale. Deferred maintenance, cut marketing spend, delayed hiring, and stretched vendor payments all produce short-term profit that a buyer cannot repeat.
That pattern is common and it is transparent to anyone who examines three years instead of one.
EBITDA Adjustments: Where the Number Moves
This is the heart of the exercise and where sellers experience the most surprise.
Reported EBITDA gets adjusted up and down to arrive at adjusted EBITDA, the figure the purchase price multiple actually applies to. At a five times multiple, a $200,000 adjustment moves the price by a million dollars. The stakes are exactly that direct.
Add-backs that usually survive
Legitimate add-backs increase EBITDA because the expense will not continue under new ownership.
Owner compensation above market rate is the classic example. If you pay yourself $500,000 and the market rate for your role is $200,000, the difference is typically added back. Personal vehicles, family members on payroll who do not work in the business, personal travel, and one-time legal fees from a resolved dispute often qualify too.
Documentation determines whether these hold. An add-back you can prove with an invoice survives. One you assert from memory does not.
Adjustments that reduce EBITDA
Sellers rarely anticipate this direction, and it is where deals lose value.
Common downward adjustments include unrecorded expenses, deferred maintenance the buyer will have to fund, below-market rent paid to an entity the seller owns, and missing costs the business will incur as a standalone operation. Companies that share services with an affiliate frequently discover the true cost only during diligence.
Non-recurring revenue comes out as well. A one-time project or a pandemic-era spike inflates the base without indicating future performance.
Why disputes happen here
Add-backs are judgment calls, not arithmetic. Buyers argue for fewer, sellers for more, and both positions can be defensible.
Preparation decides these arguments. A seller with clean records and a documented rationale wins adjustments that a disorganized seller simply loses.
The Working Capital Peg
Working capital receives less attention than EBITDA and costs sellers real money at closing.
Most purchase agreements require the seller to deliver a normal level of working capital at closing, defined by a target figure called the peg. The QofE analysis usually sets that target by examining historical averages across twelve to twenty-four months.
How the true-up works
Deliver working capital above the peg and the price adjusts upward. Deliver less and it adjusts downward.
That adjustment happens after closing, often sixty to ninety days later, and it settles in cash. Six-figure swings are ordinary in deals this size.
Where sellers lose
Seasonal businesses get hurt when the peg is calculated from an average that does not match the closing month. A company closing in its low season may need to fund a gap that reflects nothing about its performance.
Collection practices matter too. Aggressively collecting receivables and delaying payables before closing looks like a smart cash grab. It reduces working capital, and the true-up claws it back.
Understanding the peg mechanics before you negotiate them is far cheaper than discovering them afterward. This is exactly the kind of provision we review for clients at Carbon Law Group, because the accounting definition and the contract language have to line up precisely.
Preparing as a Seller
Buyers commission the QofE, but sellers control almost everything it finds.
Start eighteen months out
Meaningful cleanup takes time. Move to accrual accounting if you have not. Separate personal expenses from business expenses going forward. Document the ones already in the books.
Build a customer revenue schedule. Reconcile your books to your bank statements monthly. None of this is exotic, and all of it is visible in the report.
Consider a sell-side QofE
Commissioning your own analysis before going to market costs money and routinely pays for itself.
You learn what the buyer will find while you still have time to fix it or explain it. You enter negotiations with a defensible adjusted EBITDA rather than reacting to someone else’s. And you avoid the worst outcome in any deal, which is a surprise that arrives after the buyer has leverage.
Sellers who skip this step often face a retrade, meaning the buyer reduces the price after diligence. Retrades are common in this market and they are largely preventable.
Assemble the file early
Buyers request three years of financial statements and tax returns, bank statements, aged receivables and payables, customer revenue detail, payroll records, and documentation for every add-back you intend to claim.
Gathering that under deadline pressure produces gaps. Gaps produce doubt, and doubt costs multiple.
How Legal and Financial Diligence Work Together
A QofE is an accounting engagement. Your accountants perform it, and no attorney should pretend otherwise.
The legal work sits alongside it, and the two have to connect.
Findings from the report flow directly into the purchase agreement. The adjusted EBITDA sets the price. The working capital analysis becomes the peg and the true-up mechanism. Identified risks turn into specific indemnities, escrow amounts, or earnout structures.
Pankaj Raval and our team at Carbon Law Group work with Los Angeles business owners on the legal side of these transactions, coordinating with your accountants so the deal documents reflect what the financial analysis actually found. Our value-based pricing exists partly for moments like these, when you need to ask questions during a live negotiation without watching a meter run.
We also handle the parallel legal diligence, including entity records, contract assignability, intellectual property ownership, and worker classification exposure. Those issues surface in the same window and belong in the same conversation.
If you are considering a sale or an acquisition in the next two years, the preparation window is open now. Contact Carbon Law Group at carbonlg.com to talk through what your transaction will require.
Take the next step book your consultation today, and safeguard your brand’s future.
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