What Happens in a Quality
of Earnings Analysis
(And How to Prepare)

Most founders who have not been through an M&A process before conflate a quality of earnings analysis with an audit. They are fundamentally different exercises, and understanding the distinction is the first step to preparing for one effectively.

An audit is a backward-looking compliance exercise. Its purpose is to verify that your financial statements conform to GAAP and that your accounting policies are consistently applied. An audit gives investors and lenders confidence that your numbers are accurate — but it does not tell them whether those numbers are a reliable indicator of the ongoing earning power of the business.

A quality of earnings analysis is a forward-looking valuation exercise. Its purpose is to determine the 'true' EBITDA or earnings of the business — the normalized, recurring, cash-generative earnings that a buyer is actually acquiring. QoE analysts are specifically trained to identify adjustments that reduce (or occasionally increase) the adjusted EBITDA a buyer is willing to pay a multiple on. Every dollar of EBITDA they adjust away is worth a multiple of that in purchase price.

QoE analyses are commissioned by buyers as part of their due diligence process — typically after an LOI has been signed and before the definitive agreement is executed. But the most sophisticated sellers commission their own sell-side QoE before going to market, precisely because it allows them to identify and address issues before a buyer does, and to control the narrative around any adjustments that cannot be eliminated.

QoE analysts follow a structured methodology, but their attention is not evenly distributed. There are five areas where the most significant adjustments are typically found — and where founders who are unprepared tend to lose the most value.

The first is revenue recognition. Analysts will examine whether your revenue is recognized in accordance with GAAP (or your stated accounting policy), whether there are any timing differences between cash received and revenue recognized, and whether any revenue has been pulled forward from future periods. For SaaS businesses, this means a detailed review of deferred revenue balances, contract terms, and the treatment of professional services and implementation fees.

The second is one-time and non-recurring items. Analysts will identify any expenses or income items that are genuinely non-recurring — one-time legal settlements, restructuring charges, COVID-related expenses, or gains on asset sales — and adjust them out of the normalized EBITDA. This can work in your favor (removing one-time expenses increases adjusted EBITDA) or against you (removing one-time income reduces it). The key is to have a defensible, documented position on each item before the analyst asks.

The third is owner-related adjustments. In founder-led and closely held businesses, it is common for the income statement to include expenses that are personal in nature — above-market owner compensation, personal vehicle expenses, family member salaries, or discretionary travel. Analysts will identify these and add them back to EBITDA, which is generally favorable to the seller. But they will also scrutinize whether any legitimate business expenses have been run through personal accounts and are therefore understated.

The fourth is working capital analysis. QoE analysts will examine the normalized working capital of the business — the net current assets required to operate it on an ongoing basis — and compare it to the working capital peg agreed in the purchase agreement. Unexpected working capital deficiencies at close are one of the most common sources of post-close disputes in M&A transactions.

The fifth is customer concentration and revenue quality. Analysts will examine the composition of your revenue base — the distribution across customers, the contract terms and renewal rates, the mix of recurring versus non-recurring revenue, and any unusual or at-risk customer relationships. High customer concentration or deteriorating renewal rates are significant red flags that will affect both the adjusted EBITDA and the valuation multiple.

A buy-side QoE is typically commissioned after an LOI is signed and before the definitive agreement is executed — a period that usually runs 30–60 days in a well-run process. The buyer engages a third-party accounting firm (typically a Big Four or regional firm with M&A advisory practices) to conduct the analysis. The QoE team will request a substantial volume of financial data and documentation, and will conduct management interviews to understand the business and its accounting policies.

The initial data request is usually extensive. Expect requests for three years of audited or reviewed financial statements, monthly management accounts, detailed revenue schedules broken down by customer and product, accounts receivable aging reports, deferred revenue schedules, payroll records, and general ledger detail for selected accounts. The more organized and complete your data room is at the outset, the faster and smoother the process will be.

Management interviews are a critical component of the QoE process. The analysts will want to speak with the CFO (or equivalent), the controller, and often the CEO. They will ask detailed questions about your accounting policies, your revenue recognition methodology, the nature of specific line items on your income statement, and the business context behind any unusual fluctuations in your financials. These interviews are not adversarial — but they are probing, and unprepared management teams often inadvertently introduce issues by providing inconsistent or incomplete answers.

The output of the buy-side QoE is a detailed report that presents the analysts' adjusted EBITDA — the 'quality of earnings' — along with a schedule of all adjustments and their rationale. This report becomes a key input to the buyer's valuation and the negotiation of the purchase price and working capital peg. In a competitive process, the QoE report can be the difference between a deal closing at the LOI price and a deal being renegotiated significantly downward.

The conventional wisdom in M&A is that the QoE is the buyer's tool. In practice, the most sophisticated sellers have learned to flip this dynamic by commissioning their own sell-side quality of earnings analysis before going to market. The strategic advantages are substantial.

First, a sell-side QoE gives you control of the narrative. When you identify adjustments yourself — before a buyer does — you can present them proactively, with context and documentation, rather than being put on the defensive when a buyer's analyst surfaces them during diligence. A buyer who discovers an issue on their own will always interpret it less charitably than one who was told about it upfront.

Second, a sell-side QoE allows you to fix what can be fixed. Some issues that a QoE analyst identifies are accounting or presentation issues that can be corrected before going to market — reclassifying expenses, cleaning up revenue recognition, or addressing working capital anomalies. Others are genuine business issues that cannot be eliminated but can be contextualized. Knowing which is which before you start a process is invaluable.

Third, a sell-side QoE accelerates the buy-side process. When a buyer's QoE team receives a well-prepared sell-side QoE along with the data room, they can often complete their work faster and with fewer management interviews. In a time-sensitive process, speed is a significant advantage — it reduces the window for deals to fall apart and maintains the competitive tension that drives better terms.

The cost of a sell-side QoE for a business in the $10M–$100M revenue range is typically $50,000–$150,000. Against a transaction where even a 0.5x multiple improvement on $5M of EBITDA is worth $2.5M, the ROI is compelling.

The single most effective way to prepare for a quality of earnings analysis is to build the financial infrastructure that makes your numbers defensible before a buyer ever engages an analyst. This means more than having audited financial statements — it means having a financial reporting system that produces reliable, consistent, well-documented numbers that can withstand a detailed third-party examination.

Start with your revenue recognition policy. Document it explicitly, apply it consistently, and make sure your accounting system reflects it accurately. For SaaS businesses, this means ensuring your deferred revenue schedule reconciles to your contract terms, your ARR schedule is accurate and auditable, and your professional services revenue is recognized appropriately. Revenue recognition is the area where QoE analysts find the most significant adjustments in software businesses.

Next, build a schedule of non-recurring items. Go through the last three years of your income statement and identify every item that is genuinely one-time or non-recurring — and every item that a buyer might argue is non-recurring even if you believe it is ongoing. Document the business context for each item and prepare a defensible position on how it should be treated in the adjusted EBITDA calculation. This schedule will become the foundation of your adjusted EBITDA presentation.

Review your working capital dynamics carefully. Understand what your normalized working capital looks like on a monthly basis, how it fluctuates seasonally, and what the appropriate working capital peg should be in your purchase agreement. Working capital disputes are among the most common sources of post-close litigation in M&A transactions — and they are almost always preventable with proper preparation.

Finally, clean up your general ledger. Ensure that expenses are coded consistently and accurately, that personal expenses are clearly separated from business expenses, and that any related-party transactions are properly documented and disclosed. A messy general ledger is a red flag that signals to QoE analysts that there may be more issues to find — and it motivates them to look harder.

While every QoE analysis is unique to the business being examined, there is a relatively consistent set of adjustments that appear repeatedly across transactions. Understanding these common adjustments — and how to address them proactively — is one of the most practical things a founder can do to protect their exit valuation.

Excess owner compensation is one of the most common add-backs in founder-led businesses. If you are paying yourself significantly above market rate for your role, a QoE analyst will identify the excess compensation as a non-recurring item and add it back to EBITDA. This is generally favorable to the seller — but it requires documentation of market compensation rates for comparable roles.

One-time professional fees are another frequent adjustment. Legal fees related to a specific litigation, investment banking fees, or one-time consulting engagements are typically added back. However, recurring legal and professional fees that are part of normal operations are not — and the line between the two is often contested.

Revenue timing adjustments are particularly common in businesses with complex contract structures. If your revenue recognition policy results in revenue being recognized in a different period than when cash is received, analysts will examine whether the timing is consistent and appropriate. Aggressive revenue recognition — pulling revenue forward from future periods — is one of the most serious findings a QoE can produce.

Customer concentration discounts are not technically a QoE adjustment, but they often emerge from the QoE process. If a single customer represents more than 15–20% of your revenue, analysts will flag it as a risk factor that affects both the quality of your earnings and the appropriate valuation multiple. Diversifying your revenue base before going to market — or at minimum having a credible plan for doing so — is important preparation.

Common QoE Adjustments Reference

Tim is the founder of Pelagic Partners and brings 20+ years of operating finance leadership to venture-backed startups and growth-stage companies. He served as SVP Finance at Drata, where he helped scale the company to $150M+ ARR, and previously led finance at Qualcomm Ventures. He has raised $400M+ in capital and executed $250M+ in M&A transactions. Tim holds an MBA, JD, and BS in Finance.