Quality of earnings in due diligence
How a quality-of-earnings report tests a seller’s adjusted EBITDA: which add-backs hold (one-offs, owner pay) and which don’t (recurring “restructuring”, pro forma price rises).
The QoE report
Due diligence is the buyer checking what it agreed to buy, before the money moves. The centerpiece is the quality-of-earnings (QoE) report: forensic accountants rebuild EBITDA from the ledger, line by line. The price was set on the seller’s EBITDA. The QoE says which part of it is real.
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The work happens in a data room: a shared drive of contracts, ledgers, bank statements and tax returns that the seller opens once a letter of intent (the signed offer, price “subject to diligence”) is in place.
The seller usually commissions its own QoE before the sale. The buyer commissions another. The two reports rarely agree, and the gap is what gets negotiated.
Add-backs
An add-back is a cost the seller says won’t come back under a new owner, so it adds it back to EBITDA. Some are fair: a one-off lawsuit, or an owner paying themself above a market salary. Every dollar matters, because the buyer pays a multiple of it.
| Reported EBITDA (audited accounts) | 43 |
| + Lawsuit settlement | 2 |
| + Owner salary above market | 1 |
| + “Restructuring” | 2.5 |
| + Pro forma price increase | 1.5 |
| Seller-adjusted EBITDA | 50 |
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Owner normalization is the classic fair add-back. If Gus pays himself well above what a hired CEO would cost, the excess goes away when he leaves, so it is added back. If he paid himself too little, the buyer should take the difference off.
Recurring isn’t one-off
Biscuit Barrel has booked “restructuring” four years running. A cost that comes back every year is not a one-off. It is a cost. So is a price increase that hasn’t happened yet: 2.5 and 1.5 come out.
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The test for any add-back: will a new owner pay this next year? If yes, it stays in EBITDA, whatever the label says.
Run-rate and pro forma
A pro forma number shows earnings as if something had happened all year: a new contract, a price rise. A run-rate takes a recent month and multiplies it up. Both describe a future the seller hopes for, and the buyer is paying for the past.
| Reported EBITDA | 43 |
| + Accepted add-backs | 3 |
| Diligence EBITDA | 46 |
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If the price rise is real, the seller can be paid for it when it shows up: part of the price becomes an earn-out, paid only if the earnings arrive.
Key terms
- Due diligence
- The buyer’s check of a company before closing: the books, contracts, debts and cash behind the seller’s numbers.
- Data room
- The shared folder where a seller puts its ledgers, contracts and statements for the buyer to examine.
- Letter of intent
- A signed offer that sets the price and terms, subject to due diligence. Usually gives the buyer a few weeks of exclusivity.
- QoE report
- Quality-of-earnings report: accountants rebuild EBITDA from the ledger and test every adjustment the seller made.
- Add-backs
- Costs a seller adds back to EBITDA because they won’t recur. Fair for one-offs; not for costs that come back every year.
- Run-rate
- A recent period annualized, e.g. last month × 12. A forecast dressed as a result.
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