Direct Answer: A Quality of Earnings (QofE) analysis is a financial review commissioned by a buyer after a Letter of Intent is signed. It examines whether the revenue, EBITDA, and working capital reported by the seller accurately reflect the true, sustainable economics of the business. When a QofE reveals gaps between reported and adjusted financials, the purchase price is reduced accordingly — often by amounts that significantly surprise founders who did not see it coming.
What Is a Quality of Earnings Analysis?
A Quality of Earnings analysis is not an audit. It is more invasive and more buyer-focused than a standard financial audit, and it is designed to answer a specific question: if we acquire this business and run it without the founder, without the related-party relationships, and without the one-time items that inflated last year’s results, what does the business actually earn?
The QofE is commissioned by the buyer and performed by an accounting firm they select, typically one of the large national or regional firms with dedicated transaction advisory practices. The seller funds it indirectly — QofE costs typically run $50,000 to $150,000 or more depending on complexity, and these costs are often treated as a transaction expense that reduces net proceeds.
The process typically takes four to eight weeks and runs in parallel with legal due diligence. It is one of the most consequential periods in any M&A transaction because it is the moment when the buyer’s initial valuation assumptions are tested against the underlying reality of the business.
Why QofE Leads to Price Adjustments
The gap between what founders report and what QofE reveals is rarely the result of fraud. In most cases, it reflects how founders naturally present their businesses — optimistically, in the context of their own understanding of the company — without anticipating how a financially sophisticated buyer’s accounting team will reconstruct the numbers from scratch.
The most common sources of downward price adjustment fall into three categories: revenue normalization, EBITDA adjustments, and working capital pegs.
The Three Mechanisms That Drive Price Haircuts
1. Revenue Normalization
Revenue normalization is the process of stripping your reported revenue down to what is genuinely recurring, contractual, and transferable to a new owner.
| Revenue Item | How Buyers Treat It |
|---|---|
| Contracted ARR with formal MSA | Included at face value |
| Month-to-month agreements without contracts | Discounted or excluded |
| One-time implementation fees | Excluded as non-recurring |
| Revenue from related-party customers | Scrutinized; often partially excluded |
| Revenue from customers with verbal or informal arrangements | Excluded or heavily discounted |
| Revenue from a founder-relationship account with no formal contract | Excluded entirely |
| Revenue dependent on founder’s personal relationships | Discounted for key-man risk |
The most dangerous category is revenue that exists because of the founder personally, not because of the product or the customer relationship with the company. If a significant customer does business with you because they know you, a buyer will ask what happens to that revenue when you exit. If the honest answer is uncertain, the revenue gets discounted.
2. EBITDA Adjustments
Adjusted EBITDA is the number buyers actually underwrite to, not your reported EBITDA. The adjustments flow in both directions.
Add-backs that increase adjusted EBITDA (favorable to seller):
- Non-recurring legal or transaction fees
- One-time restructuring costs
- Founder salary above or below market rate (normalized to market)
- Personal expenses run through the business (owner’s vehicles, travel, etc.)
- Depreciation on assets being excluded from the transaction
Reductions that decrease adjusted EBITDA (unfavorable to seller):
- Missing market-rate management costs (if founder compensation was below market)
- Shared services from a parent or related entity that will no longer be available
- Costs the business will need to incur post-close that are currently being absorbed elsewhere
- Understated expenses that were deferred or delayed
The net of these adjustments is your adjusted EBITDA. For most founder-led businesses, the adjusted EBITDA comes in lower than the reported figure, sometimes materially lower, because the cost structure of running the business as a standalone entity under professional management is higher than what the founder paid themselves.
3. The Working Capital Peg
The working capital peg is the mechanism that surprises founders most frequently and most painfully, because it is rarely explained clearly at the time the LOI is signed.
Here is how it works: the LOI establishes a target working capital amount — the level of net current assets the business should have on the closing date to operate normally. This target is set based on the historical average working capital of the business, typically calculated over the trailing twelve months.
If actual working capital on the closing date comes in below the target peg, the purchase price adjusts down dollar for dollar. If it comes in above, the price adjusts up.
Working Capital Peg Example:
| Item | Amount |
|---|---|
| Agreed purchase price | $25,000,000 |
| Target working capital peg | $2,500,000 |
| Actual working capital at closing | $1,800,000 |
| Working capital shortfall | $700,000 |
| Adjusted purchase price | $24,300,000 |
The $700,000 reduction happens automatically under the purchase agreement mechanics. Founders who did not understand the peg mechanism when they signed the LOI often discover this adjustment at the closing table, at which point there is little they can do about it.
Common reasons closing working capital comes in below peg include accelerating collections to make the business look cash-rich before signing, deferring payments to vendors in a way that inflates short-term cash, and not accounting for seasonality in the working capital calculation.
The QofE Timeline: What to Expect
| Week | Activity |
|---|---|
| 1–2 | Buyer’s accounting firm sends initial data request list. Seller’s team populates the virtual data room with financial records, contracts, and supporting documentation. |
| 2–3 | Accounting firm reviews financial statements, revenue recognition policies, and customer contracts. Management calls begin. |
| 3–5 | Deep dive on revenue quality, EBITDA adjustments, and working capital analysis. Preliminary findings shared informally. |
| 5–6 | Draft QofE report delivered to buyer. Adjustments identified and quantified. |
| 6–8 | Negotiation of adjustments between buyer and seller. Purchase price re-traded if material gaps are found. |
| 8+ | Final QofE incorporated into purchase agreement. Working capital peg set. Deal moves toward closing. |
How to Run Your Own QofE Before Going to Market
The single most effective thing a founder can do to protect their valuation is commission their own Quality of Earnings analysis before the formal process begins. This is called a sell-side QofE, and it fundamentally changes the dynamic of the buyer’s diligence.
A sell-side QofE does three things. First, it tells you exactly where your adjustments will come from before the buyer finds them. Second, it allows you to address fixable issues before they become negotiating leverage for the buyer. Third, it signals to sophisticated buyers that you have done the work, which builds confidence and reduces the likelihood of aggressive re-trading.
The Sell-Side QofE Checklist:
- Reconcile all revenue to signed contracts. Any revenue without a formal agreement needs to be documented or excluded from projected ARR.
- Identify and categorize all non-recurring revenue items for the last three years.
- Calculate your market-rate adjusted EBITDA. What would the P&L look like if every role were filled at market compensation?
- Identify all shared costs from related parties, parent companies, or founders personally that will need to be replaced post-close.
- Map every significant customer relationship. Which ones depend on your personal involvement?
- Calculate your trailing twelve-month average working capital. Understand what the peg will be before the buyer proposes it.
- Review all related-party transactions for the last three years and document the business rationale for each.
- Identify any deferred revenue, prepaid contracts, or unusual billing arrangements that could affect revenue recognition.
- Confirm that all IP ownership is clean, documented, and assigned to the company entity being sold.
- Review all significant customer contracts for change-of-control clauses that require customer consent to transfer.
The Difference Between a Good and Bad QofE Outcome
The outcome of a QofE process is not binary. It exists on a spectrum from clean — where adjustments are minimal and well-anticipated — to contested — where significant gaps between reported and adjusted financials create a protracted negotiation that sometimes terminates the deal.
What a clean QofE looks like: Adjustments are modest and largely additive. The seller had already identified and disclosed the main issues. Revenue is well-documented and primarily contracted. Working capital is at or above peg. The buyer’s accounting team finishes their work without major surprises.
What a contested QofE looks like: Buyer identifies significant revenue that the seller included in ARR but the buyer treats as non-recurring. EBITDA adjustments net to a meaningful reduction. Working capital is below peg due to pre-signing actions by the seller. Customer concentration or relationship dependency creates additional discounts. The buyer uses QofE findings to re-trade the purchase price, sometimes by several million dollars.
The difference between these outcomes is almost always traceable to how prepared the seller was before the process began. Buyers do not create gaps in QofE — they find gaps that already exist. The sellers who come out best are the ones who found those gaps first.
Frequently Asked Questions
What is a Quality of Earnings analysis in M&A? A Quality of Earnings (QofE) analysis 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, sustainability, and accuracy of the seller’s reported revenue and EBITDA to verify that the purchase price is supported by the actual economics of the business.
How much does a Quality of Earnings analysis cost? QofE costs typically range from $50,000 to $150,000 for lower middle market transactions, depending on business complexity. These costs are generally treated as transaction expenses and reduce net proceeds to the seller.
Can a QofE kill a deal? Yes. If QofE reveals material misrepresentations, undisclosed liabilities, or revenue quality significantly below what was represented, buyers may reduce the price substantially or walk away entirely. Deal terminations following QofE are most common when sellers did not disclose known issues early in the process.
What is a working capital peg in M&A? A working capital peg is a target level of net current assets established in the purchase agreement. If the business delivers less working capital than the target at closing, the purchase price adjusts down dollar for dollar. It is one of the most common sources of post-LOI price adjustments in tech M&A.
What is adjusted EBITDA in a QofE? Adjusted EBITDA is the buyer’s recalculation of your reported EBITDA after removing non-recurring items, normalizing for below- or above-market founder compensation, and adding back costs the business will need to incur as a standalone entity. The purchase price multiple is applied to adjusted EBITDA, not reported EBITDA.
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. Complex businesses or disorganized data rooms can extend this timeline significantly.
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. It is one of the most effective tools for protecting purchase price in a competitive sale process.
Telegraph Hill Advisors is a boutique investment bank based in San Francisco specializing in technology M&A for founder-led companies. We have advised on 250+ transactions and regularly guide clients through QofE preparation as part of our sell-side process. If you are thinking about a sale in the next one to three years, understanding your Quality of Earnings picture now is one of the highest-leverage steps you can take.