The scariest phrase in a business sale, for most owners, is quality of earnings. It arrives in the letter of intent, it costs the buyer real money, it takes weeks, and nobody explains what it is.
So here’s what it is, what it tests, and what you can do about it before it happens to you.
It is not an audit
An audit asks whether your financial statements are accurate under accounting rules. A quality of earnings review asks a different and more useful question: how much of this company’s reported earnings will still be there next year, under a different owner.
The distinction matters because a business can have clean, accurate books and terrible earnings quality. Revenue that all comes from two customers is accurately reported and dangerously concentrated. A record year driven by one project that won’t repeat is accurate and misleading. The audit passes. The QoE finds the problem.
Your buyer hires the provider and pays for it, often a five-figure engagement at this deal size. You will not choose them and you will not control the scope.
The seven things they test
Revenue quality and recognition. Is revenue recorded when it’s earned, and does the pattern hold up? They’ll look at cutoff around period ends, because pulling January’s revenue into December is the oldest adjustment there is and it’s the first thing anyone checks.
Revenue persistence. How much of last year’s revenue exists this year. Recurring, contracted, or repeat revenue is worth more than project revenue, which is worth more than one-time revenue. A provider will decompose your top line into those categories whether or not you’ve ever looked at it that way.
Customer concentration. What percentage of revenue and gross profit comes from your largest customer, your top three, your top five. They’ll also look at how long those relationships have run, whether they’re contracted or at-will, and whether the relationship belongs to the company or to you personally. That last one is the question behind the question.
Add-back testing. Every item on your adjustment schedule, traced to transactions. Covered at length in the last piece, so I’ll leave it there.
Proof of cash. They tie reported revenue to bank deposits. It’s a basic test and it catches things.
Working capital. This is the one that moves the most money and the one owners understand the least. More on it below.
Deferred spending. Maintenance you haven’t done, equipment at the end of its life, systems you’ve put off replacing. A provider building a picture of normalized earnings will find the three years you underspent on capital expenditure and treat the savings as borrowed rather than earned.
Working capital is where the money is
Most owners spend their preparation energy on the add-backs, which are visible and feel like the negotiation. Meanwhile the working capital peg, which almost nobody understands going in, routinely moves more dollars at closing.
Here’s the mechanic. Nearly every deal is structured cash-free and debt-free, which means the buyer expects to receive the business with a normal amount of working capital in it: enough receivables, inventory, and payables balance to run the company without writing a check on day one. The parties agree on what normal looks like, usually an average of the trailing twelve months. That’s the peg.
At closing, actual working capital gets measured against the peg. Above it, the buyer pays you the difference. Below it, the price comes down.
Three things follow from that, and they’re worth more than they look.
The peg is negotiated, not calculated. There is judgment in which months you average, whether you smooth for seasonality, and how you treat unusual items. A seasonal business that sets its peg using a twelve-month average including its two heaviest inventory months is starting from a number it will have to hit at a moment when it naturally won’t.
The methodology should be settled in the letter of intent, in writing, not deferred to the purchase agreement. Deferring it means negotiating a number worth hundreds of thousands of dollars at the point in the process where you have the least room to push back.
And collecting your receivables aggressively before closing does not help you. It converts a receivable into cash, cash usually goes to the seller, and working capital drops below the peg. You’ve moved money from one pocket to another and paid a price adjustment for the privilege.
What earnings quality actually means
Strip away the vocabulary and a provider is answering one question for the buyer: how confident should I be that this number repeats?
High-quality earnings are recurring, diversified across customers, cash-backed, and not dependent on any single person. Low-quality earnings are lumpy, concentrated, dependent on the owner’s relationships, or produced by an unusual year.
Two businesses reporting identical adjusted EBITDA can be worth materially different amounts for this reason alone. That is not a technicality. It’s most of the difference between a four times multiple and a six.
What happens when they find something
They will find something. On every deal, in every business, at every size. The question is never whether the review produces findings. It’s what happens to them.
Findings resolve one of three ways.
Some get explained. The provider flags a revenue drop in a quarter, you show them the customer who moved a project by six weeks, and it goes away. These are the majority, and they go away faster when the seller answers in a day rather than a week.
Some get priced. Customer concentration doesn’t get explained away. It gets converted into an earnout, a larger escrow, a longer transition commitment, or a lower number. What you’re negotiating at that point is not whether the issue exists but how much of the risk you keep.
And some end the deal. Usually not because the finding itself is fatal, but because it’s the third one, and the buyer has started wondering what else is under there.
That last mechanism is worth sitting with. A single significant finding rarely kills a transaction at this size. An accumulation of small ones does, because the accumulation stops being about the numbers and starts being about whether the seller is a reliable narrator. Once a buyer is asking that question, every subsequent answer is read differently.
Which is the entire argument for the next section.
Run it against yourself first
Everything above is knowable before a buyer ever sees your financials. That’s the argument for doing your own version of the review while you still have time to fix what it finds.
A self-review does three things.
It finds the problems while they’re still fixable. Customer concentration at 40% is a discount if a buyer finds it in diligence. It’s a project if you find it two years out, and two years is enough time to move it.
It removes surprise from the process. The worst moment in a sale is not bad news. It’s bad news the seller clearly didn’t know about, because the buyer immediately wonders what else you don’t know. Deals die there.
And it changes the negotiation. When the buyer’s provider surfaces an issue you documented six months ago, with your own explanation attached, it’s a known item being confirmed. When they surface it cold, it’s a discovery, and discoveries get priced.
The order to do it in
If you’re preparing, work in this sequence.
Start with revenue. Decompose the last three years into recurring, repeat, and one-time. Then break it out by customer and calculate concentration by gross profit rather than revenue, because that’s the number that matters and it’s usually worse.
Then working capital. Build the trailing twelve-month average, understand your seasonality, and know what your peg should look like before anyone proposes one.
Then the add-backs, documented to transactions.
Then owner dependency, honestly. Which relationships are yours rather than the company’s. What decisions only you make. What happens in the two weeks you’re gone.
None of it requires special software. Most of it requires being willing to look.
The thing nobody says
A quality of earnings review is not an obstacle in the transaction. It is the transaction. It’s the moment a buyer decides whether the number in the letter of intent was real.
Sellers who treat it as an inspection to survive negotiate from the back foot for sixty days. Sellers who’ve already run it against themselves are just confirming what they said.