The Critical Role of Quality of Earnings in M&A: Balancing Buyer and Seller Interests
In the high-stakes arena of mergers and acquisitions (M&A), the Quality of Earnings (QoE) report has emerged as an indispensable tool for both acquirers and sellers. This financial deep dive transcends traditional audits by scrutinizing the sustainability, reliability, and operational drivers of a company’s earnings. For buyers, QoE analysis mitigates the risks of overpayment and post-acquisition surprises by separating core earnings from financial noise. For sellers, it serves as a strategic asset that validates financial narratives, justifies valuation multiples, and accelerates deal timelines. As M&A activity grows increasingly complex, understanding how QoE creates value on both sides of the transaction table becomes paramount.
Decoding Quality of Earnings: Beyond Financial Statements
A Quality of Earnings report is not merely a recast income statement but a forensic examination of a business’s financial engine. While audits verify historical compliance with accounting standards, QoE analyses assess whether reported earnings reflect repeatable operational performance. Certified public accountants and M&A specialists dissect revenue streams, expense patterns, and working capital dynamics to answer one critical question: How much of these earnings will persist under new ownership?
The process typically centers on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), adjusted to remove non-recurring items and owner-specific anomalies. For instance, a company paying above-market rent to a related entity might see that excess cost added back to EBITDA, as a buyer would negotiate fair-market lease terms post-acquisition. These adjustments transform accounting profits into a clearer picture of sustainable cash flow—the foundation of transaction valuations.
The Buy-Side Perspective: How QoE Protects Acquirers
Achieving Information Parity in Asymmetric Negotiations
M&A transactions inherently favor sellers in information access. Business owners possess intimate knowledge of customer dependencies, supplier risks, and accounting nuances that may elude even thorough financial reviews. A 2025 study cited in sell-side QoE analyses revealed that 63% of buyers discovered material financial discrepancies during due diligence that weren’t apparent in initial disclosures.
QoE bridges this gap through:
- Revenue Quality Assessments: Identifying concentration risks (e.g., over-reliance on a single client contributing 40% of sales) and verifying the recurrence of “one-time” revenue spikes.
- Expense Normalization: Flagging owner-perks like personal travel expenses booked as business costs, which inflate operational expenses artificially.
- Working Capital Benchmarking: Determining if current assets/liabilities align with industry norms, preventing post-close liquidity crises.
By converting raw financials into normalized EBITDA, buyers gain a defensible basis for valuation offers. A machinery manufacturer acquisition showcased this when QoE analysts adjusted EBITDA by $2.1 million—15% of the total—by removing non-recurring legal settlements and excess inventory write-downs. This shifted the purchase price by $14.7 million at a 7x multiple.
Uncovering Hidden Liabilities and Operational Risks
Beyond financial metrics, QoE probes operational vulnerabilities that erode long-term value:
- Customer Churn Patterns: A software firm showing steady revenue masked an 80% annual turnover in small clients, sustained only by aggressive sales incentives.
- Regulatory Time Bombs: A pharmaceutical distributor’s earnings included $3 million in pandemic-era waivers unlikely to recur.
- Tech Debt: A retailer’s “strong” EBITDA relied on deferred IT upgrades, requiring $5 million in imminent capital expenditures.
These insights empower buyers to renegotiate terms, demand escrows, or walk away from value-destructive deals.
The Sell-Side Advantage: Leveraging QoE for Optimal Outcomes Maximizing Enterprise Value Through Strategic EBITDA Optimization
Savvy sellers commission QoE analyses before bringing their business to market. This proactive move identifies EBITDA-addback opportunities that buyers might overlook. A classic example involves family-owned businesses:
Case Study: A Midwest manufacturing company paid $450,000 annually in salaries to family members who didn’t actively work in the business. The sell-side QoE team recast EBITDA by removing these excess costs, arguing that a new owner could eliminate the positions without impacting operations. At a 6.5x multiple, this single adjustment increased valuation by $2.925 million.
Common value-enhancing adjustments include:
- Owner compensation beyond fair market rates
- Discontinued business line costs
- Litigation/restructuring expenses
- Non-arm’s length transactions with related entities.
By preemptively documenting these adjustments, sellers anchor negotiations around higher valuation baselines.
Preempting Buyer Concerns Through Financial Transparency
Buyers penalize uncertainty. A 2024 analysis found that deals without sell-side QoE reports took 34% longer to close and had a 22% higher likelihood of price chipping. Sellers who provide independent QoE reports:
- Build Credibility: Third-party validation disarms buyer skepticism about financial storytelling.
- Accelerate Due Diligence: Buyers spend less time replicating basic analyses, focusing instead on strategic fit.
- Reduce Reps & Warranties Exposure: Thorough QoE disclosures minimize post-close disputes over financial misrepresentations.
A consumer goods company exemplified this by sharing a sell-side QoE that explained irregular inventory spikes as COVID-related supply chain stockpiling. This transparency prevented buyers from misinterpreting the anomaly as poor demand forecasting.
The Symbiosis of Buy-Side and Sell-Side QoE in Modern Deals Creating a Virtuous Cycle of Trust and Efficiency
When both parties engage QoE experts, transactions benefit from collaborative tension. Sell-side teams advocate for EBITDA addbacks while buy-side analysts stress-test those adjustments. This dynamic:
- Surface Mutual Insights: A healthcare IT sell-side QoE revealed $1.2 million in redundant software licenses. Buy-side analysts then quantified the savings from consolidating tools, boosting projected synergies.
- Align Expectations: Joint analysis of working capital targets prevents post-close disputes over “true” operational needs.
- Facilitate Creative Structuring: With clear EBITDA baselines, parties explore earn-outs and equity rollovers without valuation gridlock.
Quantitative Impact on Valuation Multiples
QoE quality directly influences purchase multiples through two channels:
- EBITDA Magnitude: Each dollar of sustained EBITDA added via QoE adjustments multiplied by the industry multiple (e.g., 8x for SaaS firms).
- Risk Premium Reduction: Deals with sell-side QoE reports command 0.5 — 1.5x higher multiples due to perceived lower execution risk.
A bifurcated market exemplifies this: Lower-middle-market deals without QoE support average 4.2x EBITDA, while comparable QoE-backed transactions reach 5.1x.
Conclusion: QoE as the Linchpin of Modern M&A
The evolution of Quality of Earnings from due diligence checkbox to strategic imperative reflects M&A’s increasing sophistication. For buyers, it’s a risk mitigation tool that separates operational gold from accounting pyrite. For sellers, it’s a value-maximization lever that aligns financial reporting with buyer psychology. As private equity dry powder exceeds $2.5 trillion and corporate acquirers prioritize tuck-in opportunities, QoE proficiency will distinguish successful deals from cautionary tales.
Emerging best practices suggest that dual-side QoE engagements—where both parties conduct independent analyses—will become the norm, not the exception. This collaborative approach doesn’t erase negotiation tensions but channels them into constructive financial dialogues. Ultimately, in a world where 70–90% of acquisitions fail to deliver expected returns, QoE stands as one of the few proven tools to tilt odds toward success.
If you enjoyed reading The Critical Role of Quality of Earnings in Mergers and Acquisitions, check out our article, The Family Business Dilemma: Five Forensic Fixes for Smooth Transitions by Claire Fridrickson.