How to Prepare for a Quality of Earnings: A Checklist for Sellers and Their Advisors
Short answer: To prepare for a quality of earnings, gather three years plus the trailing twelve months of financial records, reconcile the books to every bank account, convert to monthly accrual accounting if you are not already there, and document each add-back you plan to claim. Most QoE delays come from waiting on records, not from the analysis.
This is written for business owners preparing to sell and for the business brokers and sell-side bankers advising them. A buyer’s diligence team will test every number in the marketing materials. Preparation decides whether that takes three weeks or three months, and whether the price holds.
The records to gather
- Monthly financial statements and the general ledger export for the last three fiscal years and the trailing twelve months
- Bank statements for every account, including accounts the owner thinks of as personal if business money passed through them
- Federal tax returns for the same years
- Payroll registers, including owner and family compensation
- Accounts receivable and accounts payable agings at each year end and the latest month end
- Inventory counts and how inventory is valued
- Revenue by customer for each year, so the buyer can assess customer concentration
- Key customer, supplier and lease agreements, especially any with change-of-control clauses
- Debt agreements, equipment leases and any related-party arrangements
- Merchant processor statements if the business takes card payments
The books to fix before a buyer sees them
- Reconcile the books to the bank. Run a proof of cash on your own numbers before a buyer does. Revenue that does not tie to deposits is the fastest way to lose credibility in diligence.
- Close the books monthly on an accrual basis. Buyers set the working capital peg from monthly balance sheets. Cash-basis books have to be rebuilt first.
- Separate personal from business spending. Every personal expense run through the business is a potential add-back, but only if it can be identified transaction by transaction.
- Correct known classification errors. Misclassified costs, such as sales tax remittances booked against cost of goods sold, distort margins and invite questions about everything else.
Document every add-back before you market it
An add-back in the offering memorandum is a claim the buyer will test. For each one, assemble the support now: the invoice, the payroll record, the market rent comparison. See which quality of earnings adjustments hold up and which get cut, and how they feed the net working capital peg.
If the buyer is using an SBA loan
Many lower middle market buyers finance with an SBA 7(a) loan. For Initial Acquisitions and Business Expansions with a purchase price of $3 million or more, SOP 50 10 8.1 requires a quality of earnings report that the lender uses to size the loan, and the report “must not be prepared by or for the seller.” A seller-side QoE cannot be handed to the buyer’s lender. It is still worth doing: it finds the problems the lender’s QoE will find, while there is time to fix them or explain them. See SBA quality of earnings.
Sell-side QoE or a readiness review?
A full sell-side quality of earnings makes sense when the business will run a competitive process and buyers will rely on it to sharpen their bids. For smaller deals, a readiness review is often enough: a proof of cash and GAAP-formatted financials that show the books hold together before going to market.
How QoEAgent helps sellers and their advisors
Our Flash Cash Review is a fast first look at cash receipts and disbursements. Proof of Cash Plus, at a flat $10,000, delivers a complete proof of cash within 24 hours of data ingestion and GAAP-formatted financial statements, including reported EBITDA, within 48. QoE Essentials adds the normalized EBITDA schedule, working capital analysis, customer concentration and a change-of-control review. See the quality of earnings checklist, how long a quality of earnings takes, and quality of earnings report cost.