A Quality of Earnings analysis isn't an audit and isn't a forecast — it's a defensible answer to a single question: how much sustainable EBITDA does this business actually generate? The adjustments that hold under buyer scrutiny share three traits: they're well documented, they're consistently applied across periods, and they reflect economic reality rather than presentation preference. The adjustments that get rejected — synergy add-backs, owner discretionary spend without contractual support, revenue cut-off shifts, capitalization changes designed to lift EBITDA — are predictable, and identifying them before going to market protects valuation. This piece walks through the three EBITDA adjustment categories that matter, the working capital peg mechanics that determine post-close cash, the revenue-quality lens buyers apply, and the documentation that turns a sell-side QoE into a price-defending tool rather than a price-eroding one.
Most middle-market sellers approach a transaction believing the financial statements are the deal. They aren't. The deal is built on a number that doesn't appear in the audited financials — adjusted, normalized, run-rate EBITDA — and the half-dozen judgments that shape it. A Quality of Earnings (QoE) analysis is the work product that supports those judgments, and the credibility of that work product is one of the largest single drivers of final price.
Below is what buyers actually scrutinize, and what sellers can do — well before going to market — to make sure their adjustments survive diligence.
What QoE is, and what it isn't
A QoE is not an audit. It does not produce an opinion on whether financial statements are presented fairly under GAAP. It also is not a forecast — it doesn't project future performance. What it does, on a rigorous basis, is reconstruct historical EBITDA on a normalized, run-rate basis that a buyer can use to underwrite valuation.
Two flavors:
- Sell-side QoE. Commissioned by the seller, typically before going to market. Identifies the adjustments the seller will propose, supports them with documentation, and stress-tests them so the buyer's diligence team finds fewer surprises.
- Buy-side QoE. Commissioned by the buyer, performed during exclusivity. Re-tests every adjustment, identifies new ones, and produces the EBITDA number the buyer's investment committee actually uses.
A sell-side QoE doesn't preclude a buy-side QoE — buyers always do their own work. But a credible sell-side product narrows the range of what the buy-side will adjust, and accelerates the deal timeline. Both are built around the same three categories of EBITDA adjustment.
The three EBITDA adjustment categories
Every QoE adjustment falls into one of three buckets. Understanding which bucket an adjustment belongs to determines how a buyer evaluates it.
Category 1: Non-recurring (one-time)
Items that occurred in the historical period but are not expected to recur. Common examples: settlement costs from a one-time litigation matter, severance from a discrete restructuring, professional fees for the transaction itself, costs of an aborted financing, expenses tied to a specific facility relocation. These are the cleanest adjustments — they have an identifiable trigger event and a clear end date.
What buyers want to see: A specific identifying event, contemporaneous documentation (settlement agreements, severance letters, engagement letters), and confirmation that no recurring portion of the cost continues. Buyers also test for completeness — if you adjust out one-time legal fees in the trailing twelve months, they'll look at every period to see how often "one-time" legal fees appear.
Category 2: Run-rate (annualization or normalization)
Adjustments that reflect the business as it currently operates rather than as it operated historically. Common examples: full-year impact of a key hire who started mid-year, contracted price increase that took effect in month nine, rent step-up under a renewed lease, operating impact of an acquisition completed during the period.
What buyers want to see: Contractual evidence (employment agreements, signed pricing letters, executed leases) and a clean methodology for annualizing the change. Buyers will reject run-rate adjustments that lack contractual support — "we're confident the new sales rep will hit quota" is not a run-rate adjustment buyers credit.
Category 3: Owner / private-company (normalization)
Adjustments that move private-company expense levels to the level a strategic or financial buyer would incur post-close. Common examples: above-market owner compensation, family members on payroll without a corresponding role, personal vehicles or memberships expensed through the business, owner-occupied real estate at non-market rents, discretionary perks.
What buyers want to see: A specific, fact-based normalization — owner compensation reset to a market rate sourced from a defensible benchmark (compensation survey, recruiter quote, comparable executive package); rent reset to a third-party market rate; specific discretionary items identified and removed. Owner add-backs in aggregate are the most common source of buyer skepticism, because they're the most discretionary category. The remedy is granular documentation, not large round-number adjustments.
Adjustments that don't survive diligence
The adjustments buyers reject most consistently:
- Synergy add-backs. Cost savings that depend on the buyer's organization (eliminated public-company costs, shared back-office, combined procurement) belong in the buyer's investment thesis, not in the QoE. Sellers who include synergies in normalized EBITDA almost always have those adjustments removed and lose credibility on every other adjustment.
- Revenue cut-off shifts. Pulling Q1 revenue back into Q4 to "normalize seasonality," or recognizing revenue earlier than the company's documented ASC 606 policy supports. Buyers' QoE teams test cut-off explicitly and unwind aggressive timing.
- Reserve releases without economic basis. Reducing E&O, warranty, or bad debt reserves to lift EBITDA without a corresponding change in the underlying conditions. Reserve methodology should be consistent across the QoE period; changes require triggering events.
- Capitalization changes. Beginning to capitalize software development, internally developed labor, or implementation costs in the transaction year when prior periods expensed the same costs. The adjustment may be technically correct under ASC 350-40 or ASC 985-20, but it has to be applied retroactively to all QoE periods, not just the most recent.
- "Investments for growth." Adding back current-period spending characterized as discretionary growth investments. Unless the spending is genuinely non-recurring and tied to a specific completed project, it remains in run-rate EBITDA.
- Aggressive owner add-backs. Round-number owner-discretionary add-backs without itemized support, or compensation normalizations to amounts well below market for the role. Both invite the buyer's QoE team to reset the entire owner-adjustment category.
Working capital peg: the second number that determines price
EBITDA × multiple gets to enterprise value. From there, net working capital adjustments often determine final cash to seller — and the working capital "peg" mechanics are where deals quietly lose value at close.
How the peg works: The purchase agreement typically specifies a target net working capital ("the peg") representing the normal level of working capital the business carries. At close, actual working capital is computed; if it's below the peg, the purchase price is reduced dollar-for-dollar; if above, the price is increased. Post-close true-up periods (typically 60 to 120 days) finalize the calculation.
What buyers and sellers fight about:
- The peg level. Buyers want a peg that reflects the highest historical working capital level (so closing working capital tends to fall below it, reducing price). Sellers want a peg reflecting the average or lowest sustainable level. The standard methodology — trailing twelve-month average, monthly — splits the difference, but seasonality and growth dynamics matter.
- The components. Cash and debt are typically excluded. Deferred revenue is contested — buyers argue it represents an obligation the buyer must fulfill (include in working capital, reducing the calculation); sellers argue it's a financing item (exclude). The answer depends on the contracts and on how the parties define net working capital in the SPA.
- Reserves at close. If the buyer adjusts inventory reserves, AR allowances, or accrual estimates upward at close, working capital drops and price drops. Sell-side QoE work that locks down reserve methodologies in advance constrains this.
How sophisticated sellers handle it: Compute the trailing-twelve-month working capital monthly during the QoE work, identify the seasonality pattern, and propose a peg that accounts for the cyclicality. Document the inclusion or exclusion of each balance sheet line, with rationale. The peg conversation is most productive when the seller arrives with a defensible methodology rather than reacting to the buyer's first proposal.
Revenue quality: the lens behind every multiple
Buyers don't pay for EBITDA in a vacuum — they pay for EBITDA given the revenue base that produces it. Revenue quality analysis sits alongside the EBITDA bridge in any serious QoE.
The metrics buyers compute:
- Customer concentration. Top 5 and top 10 customer revenue, measured both as a percentage of total revenue and as a percentage of EBITDA. A 35%+ top-10 concentration narrows the buyer pool and compresses multiples; concentration above 50% can be a deal-breaker for many financial sponsors.
- Customer retention and churn. Logo retention, gross dollar retention, net dollar retention. For subscription businesses, net dollar retention above 110% supports a premium multiple; below 90% is a yellow flag.
- Cohort analysis. Revenue from customers acquired in each historical year, tracked forward. Reveals whether the business is growing because cohorts are expanding or because new logo acquisition is masking churn.
- Recurring vs. non-recurring revenue mix. Subscription, contracted, and committed revenue versus one-time and project revenue. Higher recurring mix supports higher multiples.
- Revenue cut-off and recognition policy. Conformity to ASC 606, consistency of the application, and the impact of any pending or recent policy changes on the period EBITDA.
The trap: Going to market without these metrics computed and documented. Buyers will compute them anyway, but they'll do so with their own assumptions and present the analysis in the way most favorable to the bid. A sell-side QoE that includes a clean revenue-quality section frames the conversation on the seller's terms.
The valuation math: why $1 of EBITDA isn't $1 of price
The reason QoE adjustments matter so much is the multiplier effect. At an 8x EBITDA multiple, a $500K adjustment to normalized EBITDA changes enterprise value by $4 million. At 12x, it's $6 million. For lower-middle-market deals, the typical QoE produces EBITDA adjustments equivalent to 10–25% of reported EBITDA — meaning the difference between an aggressive QoE that survives diligence and a conservative one can be tens of millions of dollars in price.
The corollary: an aggressive QoE that doesn't survive diligence is worse than a conservative one. Buyers who reset adjustments downward in late diligence don't reset back to the original aggressive number — they reset to a level that includes a credibility discount. The seller pays twice: once for the rejected adjustment and again for the loss of trust on remaining items.
The QoE that maximizes price isn't the most aggressive one. It's the one where every adjustment is documented, consistently applied, and economically defensible — so the buyer's diligence finds confirmation rather than concerns.
Documentation that turns adjustments into price
Every adjustment in a credible QoE has a paper trail. The standard package includes:
- Adjustment schedule. Each EBITDA adjustment listed by period, by category, with the dollar amount, the methodology, and a reference to supporting documentation.
- Underlying support. For each adjustment — invoices, contracts, settlement agreements, employment agreements, organizational charts, board minutes, or other contemporaneous records that establish the fact pattern.
- Run-rate methodology memos. For Category 2 adjustments, a short memo describing the calculation, the inputs, and the basis for annualization.
- Owner-compensation benchmarking. Where compensation has been normalized, the benchmark source (compensation survey, recruiter quote, comparable proxy data) and the rationale for the resulting market rate.
- Revenue-quality data room. Customer-by-customer revenue history, cohort analysis, retention metrics, and contract durations.
- Working capital schedule. Monthly trailing-twelve-month working capital with proposed peg and component definitions.
What to do six months before going to market
If a transaction is twelve months out or less, three actions move price more than anything else:
- Commission a sell-side QoE early enough to fix what it surfaces. The point of a sell-side QoE isn't to produce a marketing document — it's to identify problems while there's still time to remediate. Issues found six months pre-launch are correctable; the same issues found in the buy-side QoE become deal-eroding adjustments.
- Stop adjusting the GL toward the deal. Reserve methodology changes, capitalization-policy shifts, and recognition-timing adjustments all read as window-dressing if they happen in the year before the sale. Lock methodology two years before the planned launch and apply it consistently.
- Build the revenue-quality data room. Customer-level revenue history, retention metrics, and cohort analysis take real work to assemble. Doing it under deal pressure produces incomplete data and weaker positioning.
None of this is about creating EBITDA that doesn't exist. It's about identifying, documenting, and defending the EBITDA the business actually produces — so that the buyer's diligence reinforces the price rather than eroding it. If you're considering a transaction in the next twelve to twenty-four months and want a candid read on what your QoE is likely to surface, we'd be glad to help.
This article is for general informational purposes and should not be relied on as accounting, tax, or legal advice for any specific transaction. Please consult with your advisors.