Quality of Earnings for Professional Services Firms

A buyer signed an LOI on a 28-person civil engineering firm in Phoenix at $7.4M. Reported EBITDA of $1.5M on $9.2M of revenue. The seller's pitch leaned on "32-month average tenure" and "diversified municipal client base."

The QoE pulled timesheet data and project P&Ls. Two senior PEs were billing 1,850 hours a year against project work. Together they touched 71% of revenue. Both were 64 years old. Neither had a signed non-compete that would survive an asset sale.

The deal closed at $5.1M with $1.8M held in escrow for 36 months against retention of the two principals.

If you are buying a professional services firm this year, this post covers what a Quality of Earnings report finds and what kills these deals.

Utilization Is the Number That Matters

Professional services firms live and die on billable hours. The QoE rebuilds utilization from the timesheet system, not from the seller's deck.

A clean review pulls 24 to 36 months of timesheet data and asks:

• What is the average billable utilization by role: partner, manager, senior, associate?
• What is the difference between hours recorded and hours invoiced?
• How much time is being written off or written down before billing?
• What is realization rate on billed hours?
• How has utilization shifted over the past 12 months?

A management consulting firm in Atlanta reported 72% partner utilization. The QoE pulled the time entry system and found that 18% of partner hours were being recorded against an internal "business development" project that hit no client invoice.

Real billable utilization was 54%. The seller had been counting BD time as billable for purposes of the management dashboard. The buyer's QoE adjusted gross margin downward by 11 points.

That margin gap on $6.8M of revenue equals $750K of EBITDA. The deal repriced by $3.7M at a 5x multiple.

Realization and Collections Tell a Different Story

A timesheet says one thing. The invoice says another. The cash collection says a third. The QoE reconciles all three.

The review asks:

• What is the gap between recorded time at standard rate and billed time?
• What is the gap between billed and collected?
• How long does AR sit before collection?
• Are there any clients on aged AR who are unlikely to pay?
• Are write-offs being booked in the right period?

A regional law firm in Charlotte reported $14M of revenue and $2.8M of EBITDA. The QoE pulled the trust account, the AR aging, and the billing system.

AR over 120 days ran $1.9M. The seller had been writing nothing off for two years. Real EBITDA, after a $1.2M write-off of uncollectible accounts, was $1.6M.

The seller argued the receivables were "good." The buyer's QoE pulled five specific accounts and confirmed three had filed bankruptcy. The deal repriced by $6M at a 5x multiple before the buyer walked from the deal entirely.

This is one of the common QoE adjustments that professional services buyers miss without invoice-level testing.

Key Person Risk Defines the Multiple

Every professional services firm has a problem the seller does not want to discuss. Who owns the client relationships, and what happens if that person leaves?

The QoE asks:

• What percentage of revenue is touched by the top 1, 3, and 5 timekeepers?
• Are key timekeepers under enforceable non-competes?
• What is the age and retirement plan of the founder?
• Has the firm institutionalized any of the client relationships through dedicated account teams?
• Are there second-chair relationships on the top accounts?

An accounting firm in Dallas had a founder approaching 67. He personally serviced 22 of the firm's top 30 clients. The bench of senior managers had not been formally introduced to those clients.

The buyer's deal structure included a five-year consulting agreement at $200K per year, a $500K retention bonus for two senior managers, and a $1.2M earnout tied to revenue retention at month 36.

The reported $1.9M EBITDA carried a $200K per year structural cost the seller had not modeled. Real run-rate EBITDA dropped to $1.7M. The deal closed at $7.4M instead of the seller's $9.5M ask.

Backlog Is Not Pipeline

Sellers love to talk about pipeline. The QoE asks for signed contracts and engagement letters.

The review asks:

• What is the dollar value of signed contracts not yet performed?
• What is the average length of an engagement?
• Are there any retainer relationships with auto-renewal clauses?
• What is the historical conversion rate from pipeline to signed work?
• Are any client contracts terminable on short notice?

A digital marketing agency in Austin reported $6.2M of "contracted recurring revenue." The QoE pulled the signed master service agreements and statements of work.

Of the $6.2M, only $3.4M was under signed contract for the next 12 months. The remaining $2.8M was month-to-month or had termination-for-convenience clauses with 30-day notice.

The buyer's QoE flagged the $2.8M as at-risk revenue. The deal restructured with a $1.2M earnout tied to retention of the month-to-month accounts through month 18. The seller hit $900K of the earnout.

Owner Compensation, Partners, and the Comp Pool

Professional services firms compensate partners through a mix of W-2, draws, distributions, and bonuses. Many lower middle market firms run discretionary owner spending through the firm.

The QoE asks:

• What is total compensation by partner, including all forms of pay?
• What is the partner draw policy versus actual distributions?
• Are there family members on payroll, and what is their role?
• What discretionary expenses run through the firm: travel, vehicles, meals, conferences?
• What would total comp look like under a buyer's compensation philosophy?

A boutique investment bank in San Francisco paid the two founding partners $850K each in salary plus $1.4M in distributions. The QoE normalized the partner comp at $400K each for working managing director roles, generating $1.7M of add-backs.

But the buyer's lender pushed back on the add-back. Without the partners staying, the deal had no revenue. The bank required a five-year employment agreement at $600K each plus 35% of originated fee revenue, which absorbed most of the add-back.

Net economic add-back was $300K, not $1.7M. The deal repriced from a 7x multiple on $4.2M of EBITDA to a 5x multiple on $2.8M of EBITDA. The seller's expected enterprise value dropped from $29M to $14M.

Revenue Recognition and Project Accounting

Firms that recognize revenue over the life of a project can manipulate the timing of recognized revenue. The QoE rebuilds revenue by project to confirm the accounting matches the work.

The review asks:

• What is the revenue recognition policy: completed contract, percentage of completion, or milestone?
• Are progress estimates supported by independent project management data?
• Are unbilled receivables aging properly?
• Are loss contracts being recognized when identified?
• Are any large contracts close to completion or already complete with unrecognized cost?

An IT services firm in Denver reported $4.1M of EBITDA on $22M of revenue. The QoE pulled project P&Ls on the top 25 active projects.

Eight projects were over budget. The seller had not recognized $1.2M of accrued cost on those projects. Real EBITDA was $2.9M.

The seller's CFO had been smoothing earnings to support the sale process. The buyer caught it. The deal closed at the lower number, with a $400K post-close adjustment based on the final project close-outs.

What to Do Before You Sign the LOI

Professional services diligence breaks deals that look clean on paper. The numbers depend on hours, people, and relationships that the seller's deck cannot show.

Before you sign:

• Request three years of timesheet data, exported from the time entry system
• Request the realization report by client and by partner
• Request the AR aging with collection history on every account over $25K
• Request the project P&L on the top 25 active engagements
• Request the master service agreements and statements of work on every recurring client
• Confirm the non-compete, non-solicit, and assignment provisions for every key person
• Ask the seller's CFO directly what percentage of next year's revenue is under signed contract

Then engage a QoE provider that has worked on professional services deals. Generic financial diligence will not catch the five things that kill professional services deals.

Get Your QoE Started

Bedrock has run quality of earnings reviews on consulting firms, engineering firms, accounting practices, law firms, and digital agencies. We know what the utilization data hides, what the AR aging really means, and where the key person risk sits.

If you are under LOI on a professional services firm, book a call. We will scope the engagement, confirm timing, and start pulling the data the same week.

Schedule a consultation or email hello@bedrockqoe.com.