Direct Answer: A Quality of Earnings (QofE) analysis examines whether the revenue and EBITDA reported by a technology company accurately reflect the true, recurring, and transferable economics of the business. It focuses on two core questions: is the revenue real and sustainable under new ownership, and does the cost structure reflect what it actually costs to run this business independently? The answers to these questions determine whether the purchase price holds after LOI or gets adjusted downward.
What a QofE Is Actually Looking For
A Quality of Earnings analysis is not an audit. An audit verifies that your financials comply with accounting standards. A QofE goes further — it reconstructs your financials from the perspective of a buyer who wants to understand what they are actually acquiring, not what your accountants have certified.
The QofE is performed by an accounting firm selected by the buyer, typically running four to eight weeks in parallel with legal diligence. It produces an adjusted revenue figure and an adjusted EBITDA figure. These adjusted numbers — not your reported numbers — are what the buyer uses to validate the purchase price multiple they agreed to in the LOI.
The two areas the QofE examines most closely are revenue quality and cost adjustments.
Revenue Quality: What Counts and What Doesn’t
Revenue quality analysis is the process of determining how much of your reported revenue a buyer is willing to underwrite as recurring, durable, and transferable.
Not all revenue is treated equally. The QofE separates revenue into categories based on its durability and transferability under new ownership.
Revenue Inclusion and Exclusion Framework
| Revenue Type | How Buyers Treat It | Why |
|---|---|---|
| Contracted ARR with formal MSA | Included at face value | Legally binding, transferable, predictable |
| Month-to-month agreements without contracts | Discounted or partially excluded | No contractual protection; churn risk post-close |
| One-time implementation or setup fees | Excluded | Non-recurring; not part of run-rate revenue |
| Professional services revenue | Scrutinized; may be excluded or discounted | Often margin-dilutive and not scalable |
| Revenue from related-party customers | Heavily scrutinized | May not transfer to new owner at same terms |
| Revenue dependent on founder relationships | Discounted for key-man risk | May not survive post-close without the founder |
| Revenue from informal or verbal arrangements | Excluded | No legal basis for transfer; no protection |
| Revenue with unusual termination clauses | Adjusted for risk | Change-of-control clauses may allow customer exit |
What “Revenue Quality” Means in Practice
The single most important revenue quality question is: does this revenue exist because of the product, or because of the founder?
Revenue that exists because customers love the product and have signed formal agreements to pay for it is durable. Revenue that exists because the founder has a personal relationship with the decision-maker at the customer company is fragile — it may or may not transfer when the founder exits.
Buyers identify founder-dependent revenue through customer calls conducted during diligence. When a customer says “we work with you because of [founder name]” rather than “we work with you because of the product,” that revenue gets discounted in the adjusted revenue calculation.
The second major revenue quality question is about capitalization. Buyers will examine whether costs that should be expensed are being capitalized to make EBITDA look stronger than it is. Common examples include internal software development costs, certain customer acquisition costs, and implementation expenses that are amortized over the customer contract term. If capitalization practices are aggressive relative to industry norms, the QofE will normalize them, which reduces adjusted EBITDA.
Cost Adjustments: Adjusted EBITDA vs. Reported EBITDA
Adjusted EBITDA is the number buyers underwrite to. It is almost never the same as reported EBITDA, and for most founder-led businesses it starts lower and gets further adjusted in both directions.
Add-Backs That Increase Adjusted EBITDA
These are one-time or non-recurring expenses that a buyer would not expect to incur in a normalized operating year.
| Add-Back Type | Typical Amount | Notes |
|---|---|---|
| Transaction and legal fees | Varies | One-time; clearly non-recurring |
| Founder compensation above market rate | Significant | Normalized to market management cost |
| Personal expenses run through business | Varies | Owner vehicles, personal travel, etc. |
| One-time restructuring costs | Varies | Must be clearly documented as non-recurring |
| Litigation costs related to a specific dispute | Varies | Only if resolved or clearly non-recurring |
Reductions That Decrease Adjusted EBITDA
These are costs that are missing from the P&L because the founder absorbs them personally, or because the business benefits from shared resources that will no longer be available post-close.
| Reduction Type | Impact | Notes |
|---|---|---|
| Founder compensation below market rate | Significant | Buyer adds in market-rate management cost |
| Shared services from parent or related entity | Significant | Costs will need to be replaced post-close |
| Understated infrastructure costs | Moderate | IT, security, HR systems shared with other entities |
| Deferred maintenance or investment | Moderate | Costs that were delayed and must be incurred post-close |
| Missing roles needed to run business independently | Varies | CFO, HR, legal that founder currently handles personally |
The Capitalization Question
One of the more technical areas of EBITDA adjustment involves how costs are capitalized versus expensed. Under GAAP, certain internal development costs can be capitalized — treated as an asset and amortized over time rather than expensed immediately. When companies capitalize costs aggressively, reported EBITDA looks better than cash EBITDA because the expense is deferred.
Buyers will examine your capitalization policies relative to industry norms. If you are capitalizing a higher proportion of software development costs than comparable companies, the QofE will adjust your EBITDA downward to reflect a more conservative treatment. This is a common and frequently surprising source of adjusted EBITDA reduction in technology company QofE analyses.
How to Prepare Before the Buyer Does
The founders who emerge from QofE with the smallest price adjustments are the ones who ran their own analysis before the buyer did. A sell-side QofE — commissioned by the seller before going to market — identifies the adjustments the buyer will find and allows the seller to either fix them or disclose them proactively.
Revenue quality preparation checklist:
- Reconcile all reported revenue to signed contracts. Any revenue without a formal MSA needs to be documented or excluded from projected ARR.
- Identify and categorize all non-recurring revenue items for the last three years.
- Map every significant customer relationship. Which ones are product-driven and which are relationship-driven?
- Review all customer contracts for change-of-control clauses that allow customer exit post-acquisition.
- Confirm that all professional services revenue is clearly separated from SaaS/ARR revenue in reporting.
Cost adjustment preparation checklist:
- Calculate your market-rate adjusted EBITDA. What would the P&L look like if every role were filled at market compensation?
- Identify all costs currently absorbed by the founder personally that will need to be replaced post-close.
- Review your capitalization policies relative to industry norms. Are you capitalizing development costs more aggressively than comparable companies?
- Identify all shared services from related parties or parent entities and estimate the standalone cost to replace them.
- Document all one-time expenses for the last three years with clear business rationale.
Frequently Asked Questions
What is a Quality of Earnings analysis in M&A? A QofE is a financial review performed by an accounting firm on behalf of a buyer after a Letter of Intent is signed. It examines the quality and sustainability of reported revenue and EBITDA to verify that the purchase price is supported by the actual economics of the business.
What is revenue quality in a QofE? Revenue quality refers to the degree to which reported revenue is recurring, contractual, and transferable to a new owner. High-quality revenue is backed by formal contracts, product-driven rather than relationship-driven, and not dependent on the continued involvement of the selling founder.
What is adjusted EBITDA and how is it calculated? Adjusted EBITDA is your reported EBITDA after removing non-recurring expenses, normalizing founder compensation to market rates, adding back personal expenses run through the business, and reducing for costs that are missing because the business benefits from shared resources that will not be available post-close.
What does capitalization mean in a QofE context? Capitalization refers to treating certain costs as assets rather than expenses — deferring them from the P&L and amortizing them over time. When companies capitalize costs more aggressively than industry norms, the QofE adjusts EBITDA downward to reflect a more conservative treatment. This is a frequent source of adjusted EBITDA reduction in tech M&A.
How long does a QofE take? A typical QofE for a lower middle market technology company takes four to eight weeks from initial data request to final report delivery.
What is a sell-side QofE? A sell-side QofE is a Quality of Earnings analysis commissioned by the seller before going to market. It identifies adjustments before buyers find them, allows the seller to address fixable issues, and signals financial discipline to potential acquirers.
Telegraph Hill Advisors is a boutique investment bank based in San Francisco specializing in technology M&A. We guide clients through QofE preparation as part of every sell-side engagement. If you are thinking about a sale in the next one to three years, understanding your revenue quality and cost adjustment picture now is one of the highest-leverage steps you can take.