What is Quality of Earnings?

A Quality of Earnings (QoE) report is an independent financial-diligence analysis that adjusts the seller's reported earnings to reflect the actual ongoing economics of the business under buyer ownership. Conducted by a CPA firm specializing in M&A diligence (separate from the seller's accountant or buyer's tax CPA), it is the single most important diligence document for any ETA acquisition above $1.5M purchase price. For a self-funded searcher, the QoE is what separates serious diligence from amateur diligence. Sellers report 'EBITDA' that may include personal expenses run through the business (owner's car, country club membership, travel for family), one-time gains (insurance recovery, equipment sale), or non-recurring revenue (a contract that ended). The QoE strips these out, applies normalization adjustments, and produces an Adjusted EBITDA number that is the basis for both purchase price negotiation and SBA loan underwriting. The key sections of an ETA-grade QoE: • Reported EBITDA: starting point from the seller's financials. • Owner add-backs: personal expenses, above-market owner compensation, family member compensation that won't continue post-close. • One-time / non-recurring items: insurance settlements, gain on sale of assets, COVID-era PPP loans, lawsuit settlements. • Revenue quality: customer concentration (top 5 customers as % of revenue), revenue recognition timing, contracts ending soon. • Working capital trends: AR aging, inventory turns, AP days, normalized working capital target. • Net debt schedule: debt to be assumed vs paid off at close. • Run-rate adjustments: changes in customer base, pricing, or operating costs that materially affect forward EBITDA. • Adjusted EBITDA: the final number, with full bridge from reported to adjusted. For example, a self-funded searcher evaluating a $4M HVAC service business might receive seller-reported EBITDA of $920K. The QoE produces: - Reported EBITDA: $920K - Add-back: above-market owner compensation: +$80K (owner pays self $250K, market for replacement GM is $170K) - Add-back: owner's personal vehicle, gas, insurance: +$22K - Subtract: one-time gain on sale of old service truck: -$45K - Subtract: family member on payroll (owner's son) not continuing post-close: -$0 (he stays) - Subtract: revenue from one-time emergency-storm-response contracts (not recurring): -$110K of revenue, ~ -$35K EBITDA impact - Add-back: missing key-employee bonuses needed to retain post-close: -$25K (requires post-close incentive plan) - **Adjusted EBITDA: $917K** The purchase price negotiation now happens against $917K, not $920K. On a 4.5x multiple, that's a difference of $13.5K. Small. But on more aggressive add-backs and bigger one-time items, a QoE can move the deal value by 15-25%. The SBA implications: SBA 7(a) lenders for acquisitions REQUIRE QoE reports for loans above approximately $1M. The lender uses the QoE-adjusted EBITDA (not seller-reported) to calculate debt service coverage ratio (DSCR). DSCR must be at least 1.25x; the QoE is what gets you there honestly. Without a QoE, the lender is doing its own internal analysis with less data and tends to be more conservative; meaning lower loan amount or no loan at all. The practical workflow: 1. Engage a M&A-focused QoE firm BEFORE LOI signing if possible. Cost: $15-40K depending on deal size. Time: 3-5 weeks. 2. Provide the QoE firm with: trailing 36 months of P&L, balance sheets, tax returns, customer concentration data, employee roster with compensation. 3. The QoE firm interviews the seller and key employees, walks the operations, and verifies revenue recognition. 4. The buyer receives the QoE report (a 30-60 page document) and uses it for purchase price retrade negotiations and SBA loan submission. 5. Sellers who refuse to cooperate with QoE diligence are signaling something: either they have something to hide, or they don't understand the SBA requirement. Watch for QoE reports that lack adjusted EBITDA waterfall (showing the bridge from reported to adjusted), don't address customer concentration explicitly, or omit working capital normalization. A clean QoE has a transparent waterfall, customer concentration analysis with named top-5 disclosure, and explicit normalized working capital target with methodology. Inkvex's role with QoE is complementary, not substitutive: Inkvex flags clauses in the APA that reference QoE adjustments, identifies working-capital target mechanisms in the purchase agreement, and surfaces survival/indemnification language tied to financial misrepresentations. The risk score for the QoE-related sections of an APA ranges from 2/10 (clear waterfall, post-close adjustment mechanism) to 8/10 (vague reference to 'mutually agreed adjustments' with no methodology). This is legal information, not legal advice. Engage a qualified QoE firm and a transaction attorney for any acquisition above $1.5M.

Risk level: High. The QoE-adjusted EBITDA is the basis for purchase price and SBA underwriting. Skipping it is amateur-hour diligence. Inkvex flags quality of earnings clauses during analysis, explains the risk in clear language, and suggests negotiation language to protect your interests.

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