What is a quality of earnings analysis?

A QoE is diligence on the earnings number itself: whether the profit the seller claims is real, recurring, and transferable to a new owner. It tests the add-backs, converts cash-basis books to accrual, checks revenue recognition, and separates one-time events from the run rate. On a small acquisition it matters more than the audit, because the price is a multiple of this number and every soft dollar in it is paid for several times over.

Which add-backs are legitimate in a small business sale?

True one-time items and genuine owner discretionary costs: a lawsuit settled and done, the owner's above-market salary beyond what their replacement will cost, personal vehicles and family phones on the books, a one-off move or system implementation. The test is simple: will this cost genuinely not exist for the new owner? If the answer requires optimism, it is not an add-back.

What are aggressive add-backs to watch for?

Costs dressed up as discretionary that are really operating expenses: travel labeled personal that was actually business development, marketing cut in the sale year, deferred maintenance and skipped repairs, a working family member added back at zero even though someone must do their job, and normal repairs classed as one-time. Each one inflates the earnings you are paying a multiple on.

Do I need a QoE on a small acquisition?

On any deal where the price is a multiple of earnings, yes, scaled to the deal. On smaller deals it can be a focused review rather than a big-firm report, but the work has to happen, and cash-basis books with no accrual records make it more important, not less. Making the QoE a closing condition in the LOI keeps the leverage with you if the number moves.

Quality of Earnings: Which Add-Backs Are Real?

Short answer: The asking price is a multiple of an earnings number, and the seller built that number. A quality of earnings analysis is how the buyer rebuilds it. Every add-back that survives when it should not is not one soft dollar, it is four or five, because you pay a multiple on it. The test for every add-back is a single question: will this cost genuinely not exist for the new owner? One-time legal fees pass. Travel dressed up as personal that was really business development does not. Rebuilding the number is unglamorous work, and it moves more money than any negotiation tactic in the deal.

What a QoE actually does

Small-business financials are not audited, and most are not even accrual. A QoE reconstructs the earnings a buyer will actually see: it tests every add-back, converts cash-basis books to accrual so revenue and costs land in the right periods, checks how revenue is recognized, and strips one-time events out of the run rate in both directions. The output is the adjusted number that the multiple from the valuation should be applied to, which is why the QoE is not a formality after the price is set. It is where the price comes from.

Add-backs that pass the test

The legitimate ones share a property: the cost verifiably ends at closing. The owner's compensation above the market salary of the manager who replaces them. The personal truck, the family phone plan, the country club, provided they are really personal and really coming off. A settled lawsuit with the invoices to show it. A one-time move, a one-time system implementation. Each of these is checkable against documents, and a seller with clean add-backs will happily hand over the documents.

Add-backs that do not

The aggressive ones share the opposite property: the cost quietly continues under new ownership. Travel labeled personal that was actually customer visits, which is to say business development you will still have to fund. Marketing that was cut in the sale year to fatten the margin, borrowing next year's revenue to sell this year's earnings. A spouse on payroll added back at zero when someone still has to run the books after close. Repairs and maintenance classed as one-time when the trucks age every year. Deferred maintenance is the quietest one: skipped spending that shows up as your capital expense in year one, wearing the costume of margin today.

A pattern of aggressive add-backs is information beyond the number. It tells you how the seller negotiates, and it usually travels with the risks we screen as value vampires: weak reporting, thin controls, a business run out of the owner's head.

Using the QoE, not just having it

The finding is not a reason to feel smart, it is a reason to restructure. When the adjusted number comes in below the seller's, the price conversation re-anchors on the real earnings. When specific add-backs are arguable rather than clearly wrong, they become structure: a holdback against the disputed dollars, an escrow behind the reps, a seller note that keeps the seller invested in the number being true. And when the books cannot support diligence at all, cash-basis records, no receivables aging, inventory nobody has counted, the QoE becomes a closing condition in the LOI, so the leverage stays with you while the truth surfaces.

This is the core of the Due Diligence discipline, and its findings feed Deal Structure directly: the diligence does not kill the deal, it reshapes the deal so the surprise is priced before the wire goes out rather than after.

BluGrowth runs the earnings rebuild on every deal: the add-back file, the accrual conversion, and the restructure that turns findings into terms. Due Diligence and Deal Structure, run as one function. Buy-side only.

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