Quality of Earnings
The QoE report: validating adjusted EBITDA and stress-testing management's numbers
~20 min read
In nearly every PE transaction, the buyer commissions an independent Quality of Earnings (QoE) report before finalizing the purchase price. The QoE is produced by an accounting firm (often a Big Four or a specialized transaction advisory practice) hired by the buyer to validate the seller's financial claims. Think of it as a forensic audit of the income statement and, increasingly, the balance sheet and cash flow statement.
The core purpose is simple: Does the company actually earn what management says it earns? Sellers present an 'adjusted EBITDA' number that adds back one-time costs, normalizes owner compensation, and projects run-rate profitability. The QoE team pressure-tests every adjustment, looking for items that are aggressive, unsupported, or outright fabricated. In a deal priced at 8-12x EBITDA, every $1M of EBITDA that gets challenged or removed translates to $8-12M off the purchase price.
Common Add-Backs and How They Are Evaluated
Sellers propose add-backs to show the buyer what the business earns on a 'normalized' basis. Some are legitimate and widely accepted. Others push the boundaries. The QoE report grades each one:
- Owner compensation above market: A founder paying herself $1.5M when a market-rate replacement CEO would cost $350K. The $1.15M difference is a standard add-back that QoE firms rarely dispute.
- One-time expenses: Litigation settlements, facility relocation costs, rebranding projects, or consultant fees for a completed ERP implementation. The QoE team verifies that these expenses are truly non-recurring. If the company has had 'one-time' restructuring charges in three of the last five years, the pattern suggests they are recurring.
- COVID-related impacts: Revenue losses or excess costs attributable to the pandemic. These were widely accepted add-backs in 2020-2022, but by 2024-2025 most QoE firms treat lingering COVID adjustments with skepticism unless clearly documented.
- Non-recurring legal or regulatory costs: Defense costs for a settled lawsuit, compliance project costs for a one-time regulatory change. The QoE team confirms the matter is resolved and will not generate future costs.
- Related-party transactions at off-market terms: The owner leasing a building to the company at $35/sqft when the market rate is $24/sqft, or employing family members in roles that would not exist under new ownership.
| Adjustment Type | Legitimate Example | Aggressive Example | |
|---|---|---|---|
| Owner compensation | Founder earns $1.5M; market CEO replacement is $350K. Add-back of $1.15M. | Founder earns $400K (at market) but adds back $200K claiming the role could be filled cheaper post-close. | |
| One-time expense | $600K for a completed office relocation that will not recur. | $300K in 'one-time' sales training that the company runs every 18 months. | |
| Run-rate adjustment | Annualizing the cost of 5 employees hired in Q4 (only 3 months of cost in TTM numbers). | Projecting revenue from a new product line that has not yet generated meaningful sales. | |
| Revenue normalization | Removing a $2M one-time equipment sale that is outside core operations. | Adding back 'lost revenue' from a customer who chose not to renew, claiming it was a COVID anomaly. |
Run-Rate Adjustments and Pro Forma EBITDA
Run-rate adjustments account for changes that happened during the trailing measurement period but are not yet fully reflected in the numbers. If a company closed a $3M-per-year contract in October, the trailing twelve-month EBITDA only includes two months of that contract's revenue ($500K). A run-rate adjustment would add the remaining $2.5M to reflect the annualized impact.
The QoE team scrutinizes run-rate adjustments because they are inherently forward-looking and therefore speculative. Is the new contract certain to run for a full year? Does it have cancellation provisions? Is the margin on the new contract consistent with the rest of the business?
Pro forma EBITDA takes the concept further by combining all adjustments into a single restated earnings figure. If the company acquired a bolt-on business mid-year, pro forma EBITDA includes the full twelve months of the acquired entity's earnings, even though only six months appear in the actual financials. The QoE report will reconcile reported EBITDA to adjusted EBITDA step by step, quantifying each add-back, run-rate adjustment, and pro forma item so the buyer can see exactly where the number comes from.
A well-prepared QoE report typically presents a 'bridge' from reported EBITDA to adjusted EBITDA, sometimes with a range (low, mid, high) to reflect uncertainty in certain adjustments.
How QoE Findings Reshape a Deal
A PE fund is evaluating a $40M-revenue building materials distributor. Management presents adjusted EBITDA of $8.5M, up from reported EBITDA of $6.2M. The proposed add-backs total $2.3M:
- Owner compensation above market: $900K
- One-time warehouse relocation: $450K
- Non-recurring consulting fees (ERP): $350K
- COVID revenue recovery adjustment: $600K
The buyer's QoE firm accepts the owner comp ($900K) and warehouse relocation ($450K) in full. They accept $250K of the ERP consulting but note $100K was for ongoing support that will continue. They reject the $600K COVID adjustment entirely, finding that the revenue decline reflected a permanent loss of two customers, not a temporary pandemic effect.
QoE-adjusted EBITDA: $6.2M + $900K + $450K + $250K = $7.8M
At the agreed 9x multiple, this difference changes the enterprise value from $76.5M (management's number) to $70.2M, a $6.3M reduction. The buyer uses the QoE findings to renegotiate the price, ultimately closing at $72M after splitting the difference on the disputed COVID adjustment.
Composite example based on typical middle-market QoE engagements
Adjusted EBITDA Bridge
The adjusted EBITDA bridge starts with the company's reported EBITDA and layers on each category of adjustment. Add-backs increase EBITDA by removing non-recurring expenses. Run-rate adjustments annualize partial-period items. Pro forma adjustments incorporate the full-year impact of acquisitions or divestitures. Non-recurring revenue is subtracted because it inflated reported earnings but will not repeat. The QoE report validates each line in this bridge.
Quiz: Quality of Earnings
6 questions · ~3 min