A quality of earnings analysis is not an audit. It is an attempt to work out what the business would earn in the hands of a new owner, stripped of the choices the current owner made for reasons that had nothing to do with operating performance. Nearly every lower-middle-market business has several such choices embedded in its numbers.
None of them are improper. All of them are corrosive when a buyer discovers them and the seller appears not to have known.
One: owner expenses running through the profit and loss
The vehicle, the country club membership, the family member on payroll who has not been to the office in three years. These are add-backs and a buyer will generally accept them, but only if they are identified, quantified and supported. Presented late and defensively they read as a discovery rather than a disclosure, and the buyer starts wondering what else is in there.
Two: revenue recognized on the owner’s timetable
Invoicing in December for work that will be performed in March. Recognizing a full year of a maintenance contract on signature. These are timing choices, often made years ago for tax reasons and never revisited. A buyer normalizes them, and the normalization almost always moves earnings down in the most recent period, which is the period the multiple is applied to.
Every adjustment a buyer finds is worth its full value times the multiple. An $80,000 add-back on a six-times deal is worth nearly half a million dollars in price.
Three: the related-party lease
The building is owned by the seller personally and leased to the company below market, or above it. Either way the buyer will restate rent to market, and the difference flows straight through EBITDA. Where the property is not part of the transaction this is a straightforward adjustment. Where it is, the allocation between business and real estate becomes a negotiation of its own, with quite different tax consequences on each side.
Four: customer concentration nobody mentioned
Not an accounting adjustment but a valuation one, and often the largest single factor. A business with forty per cent of revenue from one customer trades at a different multiple from one with a spread of fifty, regardless of what the earnings look like. Concentration is not fatal, but it needs to appear in the teaser rather than in week three.
Five: the costs that arrive the day after closing
The owner who was not taking a market salary, and whose replacement will need one. The insurance that was underwritten on a personal relationship. The software licenses priced for a smaller company. Deferred maintenance on equipment. Buyers build these into the model as pro-forma costs, and every dollar of them reduces the earnings the price is based on.
The case for running it yourself first
Sell-side diligence is the highest-return spend in most owner-led transactions, and it is not close. Running the buyer’s analysis on your own side, twelve to eighteen months before a process, does three things: it gives you a normalized number you can defend, it lets you fix what is fixable while there is still time, and it removes the possibility of being surprised in front of the counterparty.
The alternative is discovering all five of these while a letter of intent is signed and the buyer holds the pen. That is not a negotiation. That is a re-trade.
This note is general information, not advice. Tax and accounting outcomes turn on specific facts and the rules change. Speak to us, or to another qualified advisor, before acting on anything here.