The 5 Quality of Earnings Mistakes Business Buyers Make

I have reviewed hundreds of deals. The pattern is the same every time.

Let’s say a first-time buyer finds a business. The seller's broker sends over a CIM with $2M in adjusted EBITDA. The buyer gets excited. They put in an LOI at 5x. Then they hire a QoE firm. And that is where the wheels come off.

Not because the QoE provider did bad work. Because the buyer made critical mistakes before the report ever started.

Here are the 5 most common ones.

1. You accepted the seller's add-backs at face value.

A seller tells you the business does $2M in EBITDA. But look closer. There is $400K in "owner add-backs." His wife's car. His country club dues. A $75K salary for a nephew who works 10 hours a week.

Those might be legitimate add-backs. Or they might be fantasy.

I worked with a buyer looking at a $4M EBITDA services business. The seller had $600K in add-backs. When we dug in, $220K of those were recurring expenses the new owner would need to replace, including a full-time office manager classified as "owner discretionary." On top of that, the seller had a below-market lease from a related entity. It was about to reset. That wasn't in the add-backs at all.

The real EBITDA was $3.4M. At a 5x multiple, that is a $3M difference in purchase price.

Your QoE provider's job is to test every add-back. But your job is to go in skeptical, not hopeful.

2. You skipped the working capital analysis.

Most first-time buyers obsess over EBITDA. They forget about working capital.

Here is why that matters. Working capital is the cash the business needs to operate day-to-day. Inventory. Accounts receivable. Minus accounts payable.

If the seller has been running the business lean on working capital heading into the sale, you are going to need to inject cash on day one just to keep the lights on.

I saw a deal where the buyer had to fund $400K on top of the purchase price out of pocket on day one just to keep the business running. The target had $800K in normal working capital needs. The seller stretched payables and ran inventory down in the months before closing. Working capital at close was $400K below the trailing average.

Your purchase agreement needs a working capital peg. Your QoE should define what "normal" looks like. If it does not, you are flying blind.

3. You hired the cheapest QoE provider.

Search fund buyers are watching every dollar. I get it. You have a $20K to $30K budget for financial due diligence and you want to stretch it.

But a QoE is not a commodity.

The difference between a $5K QoE and a $25K QoE is not the font on the cover page. It is whether the provider tests revenue recognition at the invoice level. It is whether they run a proof of cash. It is whether they know what a $2M EBITDA business in that industry should actually look like.

A cheap QoE that misses a customer concentration problem or an aggressive revenue recognition policy will cost you 10x what you saved on the fee.

4. You ignored customer concentration.

A business with $3M in revenue sounds great. Until you learn that $1.2M comes from one customer. That is 40% concentration.

Here is what that means in practice. That customer can leave. They can renegotiate pricing. They can slow pay and wreck your cash flow. And you just paid a premium multiple for revenue that is sitting on a knife's edge.

I have seen deals where a single customer accounted for 35% of revenue. The buyer closed anyway. Within 8 months, that customer left. The business went from $1.5M EBITDA to $900K overnight.

Your QoE should break down revenue by customer. But you should also talk to the top 5 customers directly. Ask about contract terms, renewal likelihood, and relationship with the current owner. If the business depends on the owner's personal relationships, that revenue is at risk the day you take over.

5. You treated the QoE as a pass/fail test.

This is one of the biggest mistakes first-time buyers make, and it’s easy to fall into.

The QoE comes back. The buyer reads the adjusted EBITDA number on page 3 and says "looks close enough" or "that is too far off, deal is dead."

Wrong approach.

A QoE is not a verdict. It is a negotiation tool.

If the QoE reveals that adjusted EBITDA is $1.6M instead of the seller's claimed $2M, that does not mean the deal is bad. It means the deal is bad AT THE CURRENT PRICE. Renegotiate. Adjust the multiple. Restructure the earnout. Build in a working capital peg.

The best buyers I work with use the QoE to make the deal better, not to kill it. The findings give you specific leverage. "Your top customer has no contract." "Your add-backs include $150K in expenses the new owner will need to replace." These are not reasons to walk. They are reasons to sharpen your pencil.

The Bottom Line

A quality of earnings report is the single most important piece of due diligence in a small business acquisition. But it is only as good as the buyer's preparation going in and their willingness to act on the findings coming out.

Get skeptical early. Hire a provider who knows your industry. And use the report as a tool, not a checkbox.

If you are working on a deal and want a second opinion on your diligence approach, book a call.

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