Quality of Earnings on LMM deals

Quality of Earnings reports used to be a feature of upper market deals. They're now standard practice on lower middle market processes. Buyers want a QofE before they sign the LOI, not after. The shift has added material time to every sell side timeline.

This piece walks through what QofE actually is, why it matters, what it costs in time and money, and how sell side advisors should account for it in process design.

What QofE is

Quality of Earnings is an analysis of a target company's financial performance, performed by a third party accounting firm. The QofE adjusts reported EBITDA for:

• One time items (legal fees, severance, restructuring costs)
• Owner specific costs (excess salary, related party expenses, personal expenses)
• Accounting policy choices that don't reflect normal operations
• Customer concentration impact on adjusted profitability
• Working capital adjustments
• Capex categorization (maintenance vs growth)

The output is "adjusted EBITDA", a number both parties use as the baseline for valuation and deal structure.

Why QofE has expanded into LMM

Three drivers:

• Buyer sophistication. Lower middle market PE platforms have institutionalized diligence processes. They run QofE on every deal because their LP base expects it. Family offices and strategic buyers are following.
• Cost compression. Boutique accounting firms now produce LMM scope QofE reports for $25K to $50K, down from $75K+ five years ago. The price point has come down to where it makes sense on smaller deals.
• Risk asymmetry. A QofE that catches an EBITDA add back issue saves the buyer a multiple times EBITDA error. The buyer's downside from skipping QofE is much larger than the cost. Once one buyer expects QofE, all buyers expect QofE.

What QofE costs in time

A buyer side QofE on a lower middle market deal typically takes 4 to 6 weeks from start to deliverable. Sometimes longer on complex businesses.

Implications for the sell side process:

The buyer cannot reasonably sign a definitive purchase agreement until the QofE is complete. So the QofE timeline sits inside the exclusivity period, not before. A typical 90 day exclusivity becomes:

• Weeks 1 to 2: QofE provider engaged, documents gathered
• Weeks 3 to 6: QofE analysis and field work
• Weeks 7 to 8: QofE report delivered, parties review
• Weeks 9 to 12: definitive agreement drafting and negotiation
• Weeks 13 to 14: closing prep
• Week 14+: close

Why sell side QofE matters

A sell side QofE produced before going to market changes the dynamic.

The seller's banker engages a boutique QofE firm in week 1 of pre sale prep. The firm produces a report over 3 to 4 weeks. The report identifies issues the seller can address before going to market:

• EBITDA add backs documented and substantiated
• One time items identified and quantified
• Owner specific costs separated and explained
• Working capital trend analysis completed
• Customer concentration disclosed and contextualized

The seller goes to market with the QofE in hand (or a redacted summary). Buyers sign the LOI with the QofE as part of the disclosure. The buyer's own QofE becomes a verification exercise (much faster, 2 to 3 weeks instead of 4 to 6) instead of a discovery exercise.

The savings: 2 to 3 weeks of exclusivity timeline, plus reduced retrade leverage from buyer "discoveries." On a deal where retrade attempts often run 5 to 10% of headline price, the $25K to $50K spent on sell side QofE often pays back many times over.

What QofE catches

Common findings in lower middle market QofE reports:

Owner specific items

• Excess salary (above market for the role)
• Personal expenses run through the business (vehicles, travel, entertainment)
• Related party transactions priced below or above market
• Family member salaries on the payroll

One time items not properly excluded

• Litigation fees and settlements
• Restructuring costs
• One time customer wins or losses
• COVID period adjustments
• Acquisition costs from prior acquisitions

Accounting policy choices

• Inventory valuation methodology (FIFO vs LIFO vs weighted average)
• Revenue recognition timing
• Capitalization vs expensing of certain costs
• Bad debt reserve methodology

Customer and supplier concentration

• Customer revenue concentration (top 10 customers as % of total)
• Customer profitability variance
• Single source supplier risks
• Recent customer wins and losses not yet flowing through historical financials

Capex categorization

• Maintenance capex vs growth capex split
• Capitalization policy and consistency
• Pending capex needs the financials don't reflect

Each of these can move the adjusted EBITDA number meaningfully. A $5M reported EBITDA can become $4.2M adjusted (downward) or $5.6M adjusted (upward) depending on the findings.

What sell side advisors should do

1. Build QofE into the timeline assumption

Pitch decks should show 90 to 120 day exclusivity, not 60 day. Set expectations with the seller from day one that QofE adds 4 to 6 weeks to LOI to close.

2. Recommend sell side QofE on deals above a threshold

For deals where the threshold is high enough to justify the cost (boutique firms produce LMM scope QofE reports for $25K to $50K), recommending a sell side QofE catches issues on the seller's timeline. Above $20M deal value, sell side QofE almost always pays back.

3. Negotiate QofE cost in the LOI

The buyer's QofE cost is a deal term. Push it to the buyer (most LMM deals end up here) or split it. Don't let it default to "seller pays" without pushback. On deals where the QofE provider charges $50K+, this matters.

What sellers should do

Run a quasi QofE internally before hiring a banker

• Pull together 3 to 5 years of monthly P&L
• Identify obvious EBITDA add backs (owner salary above market, one time items, related party expenses)
• Get owner specific costs documented (receipts, invoices, tax returns)
• Address any related party transactions

Discuss QofE prep with banker candidates

A banker who has run multiple LMM processes should be able to walk you through their QofE strategy in detail. Bankers who treat QofE as the buyer's problem are setting you up for week 6 retrade.

Budget for sell side QofE

$25K to $50K is the typical range. The cost is part of the engagement budget. Discussed upfront, not surprise at week 4.

Where to read next

For the timeline that frames where QofE work fits in the broader sell side process, see The Sell Side M&A Process: 26 Week Timeline. For the LOI terms that the QofE will pressure test in week 6 of exclusivity, see LOI and Exclusivity in LMM M&A. For the working capital line items the QofE will analyze, see Working Capital Adjustments in LMM LOIs. For the earnout decision the QofE adjusted EBITDA will anchor, see Earnout Structure in LMM M&A.