Quality of Earnings vs. Valuation: What Changes Between the LOI and Closing

A valuation and a Quality of Earnings report answer two different questions. The valuation answers "what is this business worth, given its earnings?" It sets the multiple. The QoE answers "are those earnings real, recurring, and correctly measured?" It tests the base the multiple sits on. Deals rarely re-price between LOI and closing because someone changes the multiple. They re-price because the QoE changes the earnings number the multiple is applied to.

I've watched this dynamic at every scale, including on a $26B merger, where armies of accountants fought over the earnings base while the headline multiple barely moved. In the middle market it's exactly the same game with smaller numbers: price = earnings × multiple, and diligence attacks the earnings.

What Is a Quality of Earnings Report?

A Quality of Earnings (QoE) report is an independent accounting analysis (usually performed by a CPA firm's transaction advisory group) that verifies and normalizes a company's earnings before an acquisition closes. It examines whether reported EBITDA or SDE reflects the true, sustainable earning power of the business: are the add-backs legitimate, is revenue recognized properly, are one-time items really one-time, and will the earnings recur under a new owner?

It is not an audit. The distinction matters:

The Adjustments That Actually Re-Price Deals

Across middle-market transactions, a handful of QoE findings do most of the damage:

• Rejected add-backs. The seller's "adjusted" EBITDA added back expenses that turn out to be recurring: the "one-time" marketing spend that appears three years running, or a family member on payroll who does real work and must be replaced.
• Revenue recognition timing. Deposits booked as revenue before the work is done, or year-end shipments pulled forward to fatten the trailing twelve months.
• Under-market owner replacement cost. The owner paid themselves $40K for a role that costs $120K on the market; QoE restates earnings with the real cost.
• Customer concentration surfacing. The QoE quantifies what the CIM soft-pedaled: the concentration risk buyers price hardest.
• Working capital definition. Not an earnings item, but the NWC peg negotiated off QoE schedules routinely moves six figures of value at closing.

The Re-Pricing Math (Why Sellers Feel Ambushed)

Say a deal is struck at $1,000,000 of adjusted EBITDA and a 5.0× multiple: $5.0M. The QoE rejects $150K of add-backs and restates owner compensation, landing at $850K of sustainable EBITDA. The buyer doesn't renegotiate the multiple. They simply apply the same 5.0× to the new base:

$850K × 5.0 = $4.25M. That is a $750K price cut, with the buyer able to say, honestly, "nothing changed but your own numbers."

This is the valuation gap reopening at the worst possible moment, after you've taken the business off the market and spent months in diligence. The multiple was never the risk. The earnings were.

How Buyers Should Use the QoE

For searchers and first-time acquirers, the QoE is your protection against buying a smaller business than the one you priced; your LOI range should anticipate it:

1. Budget for it. Middle-market QoE engagements commonly run in the tens of thousands of dollars. It is the least optional check in your diligence budget, and SBA lenders increasingly expect one on larger 7(a) deals.
2. Scope it to the thesis. Point the accountants at what your price actually depends on: recurring revenue, the biggest add-backs, customer concentration.
3. Pre-negotiate the mechanism. Agree in the LOI how a QoE-driven earnings change flows to price (dollar-for-dollar at the agreed multiple), so the conversation is arithmetic instead of warfare.

How Sellers Should Prepare (Before Going to Market)

• Run a sell-side QoE, or at minimum a rigorous internal one. Finding your own problems 12 months early costs a fraction of discovering them under LOI.
• Document every add-back the way a skeptical accountant would demand: invoices, contracts, payroll records.
• Normalize honestly. An adjusted-EBITDA schedule that survives diligence intact is worth more than an aggressive one that gets cut, because every rejected add-back also taxes your credibility on everything else.

Frequently Asked Questions

Is a QoE report the same as an audit?

No. An audit opines on whether financial statements follow accounting standards. A QoE specifically tests whether reported earnings are sustainable and correctly normalized for a transaction. It's narrower, faster, and deal-focused.

Who pays for the Quality of Earnings report?

Each side pays for its own: buyers commission buy-side QoEs during diligence, and sellers sometimes commission sell-side QoEs before going to market to pre-empt surprises and defend their asking price.

Can a deal die because of a QoE?

Yes, and they regularly do, but the more common outcome is a re-price. When the QoE materially reduces adjusted earnings, the buyer applies the agreed multiple to the lower base, and the seller either accepts the new price, negotiates structure (earnout, seller note), or walks.

Do small deals really need a QoE?

For deals in the low millions, a full-scope QoE may be replaced with a lighter "QoE-lite" or financial diligence review, but skipping earnings verification entirely is how buyers end up owning a business that earns less than the one they modeled.

Key Takeaways

• Valuation sets the multiple; QoE tests the earnings. Deals re-price when the earnings base moves; the multiple usually survives.
• The usual culprits: rejected add-backs, revenue timing, owner replacement cost, concentration, and the working-capital peg.
• Buyers: budget for QoE, scope it to your thesis, and pre-agree the re-pricing arithmetic in the LOI.
• Sellers: run the QoE on yourself first. Documented, honest normalization is the cheapest price protection available.

The pattern underneath all of this: whoever knows the true earnings base first controls the negotiation. ValueAlpha normalizes earnings and values the business the way the diligence team eventually will, so whichever side of the table you're on, the QoE confirms your number instead of demolishing it.