TL;DR: A quality of earnings report is not optional in a search fund deal. It is the one document that validates whether the EBITDA you are buying is real. It costs $15,000 to $50,000. It takes four to six weeks. And it regularly cuts purchase price by more than its own fee.
The seller's financial statements look clean. The accountant says the numbers check out. The broker calls it a "well-documented" business. Then you commission a quality of earnings report and find out that $400,000 of the seller's claimed $1.2M EBITDA does not survive. That is a story I have seen play out in lower-middle-market deals more times than I can count. The quality of earnings (QoE) report is the single most important due diligence deliverable in any search fund acquisition. Learn what it does, how to read it, and what to do when it surfaces a problem.
What a QoE Report Actually Does
A QoE report is not an audit. An audit confirms that financial statements conform to GAAP. It says the numbers were recorded correctly. It does not say the numbers reflect sustainable cash flow.
A QoE goes further. It stress-tests the EBITDA. It answers the question that actually matters to a buyer: how much of this earnings figure will still be there after the seller leaves?
The work is governed by AICPA Statement on Standards for Consulting Services No. 1, not audit standards. The practitioner provides no opinion on the financial statements. What you get instead is a deep reconciliation: reported EBITDA, adjusted to remove one-time items, normalize owner compensation, verify revenue quality, and establish a working capital target. That reconciliation is your acquisition price anchor.
The report typically runs 60 to 100 pages and covers three to five years of monthly financials. It does not replace legal due diligence or commercial due diligence. It runs alongside both, starting immediately after LOI.
The Five Areas That Move the Number
Every QoE follows the same structure. These five areas are where price changes happen.
1. Owner Compensation Normalization
Small businesses are frequently vehicles for owner lifestyle. The owner pays himself $250,000 in salary but the market rate for a replacement CEO is $120,000. That $130,000 difference is a legitimate add-back. But the QoE firm verifies it. They review payroll records, W-2s, and comparable compensation data. Sellers overstate this adjustment more often than they admit.
2. Non-Recurring Items
A $150,000 legal settlement. A one-time equipment purchase. A fire that shut the business for six weeks. These should be removed from normalized EBITDA. The QoE team categorizes each one. The argument about what qualifies as "non-recurring" is often the most contentious part of deal negotiations. The QoE firm's classification becomes the evidentiary basis.
3. Revenue Quality
Is revenue recurring or transactional? Is it customer-concentrated? A business reporting $3M in annual revenue that has one customer representing 40% of that figure has a materially different risk profile than the top line suggests. QoE firms run customer-level revenue testing. They verify whether the revenue recognized matches cash collected. Aggressive revenue recognition is a red flag that shows up here.
4. Working Capital Analysis
This is the area most first-time buyers miss. Working capital is the difference between current assets and current liabilities. In an acquisition, you agree to deliver the business with a certain level of working capital at close. That level, called the peg, is established by the QoE report.
If the seller delivers less working capital than the peg at closing, you get a dollar-for-dollar purchase price reduction. This single provision has meaningfully changed the economics of more deals than most buyers expect. The QoE builds the trailing twelve-month average of monthly working capital, adjusted for seasonality, to set a defensible peg.
5. Tax and Compliance Exposure
Small businesses that have expanded into new states sometimes fail to register for sales tax in jurisdictions where they have nexus. The QoE firm identifies and quantifies this exposure. A $200,000 unreserved sales tax liability in an asset sale becomes the seller's problem. In a stock sale, it is yours. Knowing the number before close gives you leverage.
What It Costs and When to Commission It
For search fund acquisitions targeting businesses with $500,000 to $5M in EBITDA, QoE fees typically run $15,000 to $50,000. Boutique transaction advisory firms and regional CPA firms with dedicated transaction practices handle most of this market.
Bigger deals cost more. For targets in the $5M to $25M EBITDA range, mid-market firms such as RSM, Grant Thornton, and BDO charge $75,000 to $150,000. Big Four fees start at $250,000 and are overkill for typical search fund targets.
Commission the QoE immediately after signing an LOI with exclusivity. Starting earlier wastes money if the deal falls apart on other grounds. Starting later compresses the closing timeline.
Expect four to six weeks from engagement letter to final report. Week one is document requests. Weeks two and three are fieldwork and model building, often involving 50 to 150 questions back to the seller. Week four is draft review. Weeks five and six are final report and presentation call.
How to Choose a Provider
Three things matter.
First, deal-size fit. A Big Four firm on a $3M enterprise value deal is the wrong match. You will pay partner fees for associate work and get a report that took longer than the deal required. Use boutique and regional firms for sub-$25M EV deals. They move faster and they understand SME accounting conventions.
Second, partner-level engagement. Ask directly: who leads the fieldwork? Junior staff on a small deal produces lower-quality output. Confirm the named partner has at least ten years of dedicated transaction services experience and will be in the room for the on-site visit.
Third, lender comfort. Your SBA lender or senior debt provider will likely require reliance on the QoE. Ask which lenders accept the firm's reliance letter without additional diligence. This matters for closing speed.
What Happens When the QoE Finds a Problem
This is the scenario operators fear and should not. A QoE that finds $300,000 in EBITDA adjustments on a $1.2M claimed figure is not a deal killer. It is a renegotiation trigger.
You have three moves. First, reduce the purchase price to reflect the lower EBITDA at the agreed multiple. A $300,000 reduction at 5x EBITDA is a $1.5M price reduction. The QoE fee paid for itself ten times over.
Second, restructure with a seller note tied to earnout. If the seller disputes the adjustment and argues the revenue will recover post-close, make him put money behind that conviction. A seller note that amortizes contingent on performance converts the dispute into aligned incentives.
Third, walk. Some problems do not reprice. Undisclosed litigation, material customer contracts that terminate on change of control, or concentrated revenue with a customer already in financial distress are not discounting events. They are exit events.
The QoE gives you the information to make the right call before you close. That is its only job. A clean QoE with minor adjustments increases your confidence in the deal. A problematic QoE with material findings gives you the basis to renegotiate or walk. Both outcomes are valuable. The one thing you cannot afford is to close without one.
The Sell-Side QoE
A growing number of sellers in the lower middle market now commission their own QoE before going to market. This is called a sell-side or vendor QoE. It signals a sophisticated seller who wants to accelerate buyer diligence and reduce deal risk.
Treat it as a starting point, not a substitute. Commission your own buy-side QoE regardless. The sell-side QoE was prepared for the seller's benefit. Your QoE firm will scrutinize the same adjustments from a different angle, and they will ask questions the sell-side team was not incentivized to surface.
One Metric That Matters
The 2024 Stanford Search Fund Study confirmed that a significant portion of search fund deals that fall apart in diligence do so because of surprises in working capital, customer concentration, or undisclosed liabilities. Not price. Those three categories are exactly what a QoE report is designed to expose.
Spend the $15,000 to $50,000. Commission it at LOI. Choose a provider who has done fifty of these, not five. The QoE report is the one investment in the diligence process that earns a positive return before the deal even closes.
For context on what happens after you sign: the working capital peg established in the QoE directly feeds the working capital peg negotiation at close. Read that next.
Patriot Growth Capital is a veteran-founded private equity firm that acquires, mentors, and invests in owner-operated businesses. Jeff Barnes has no personal position in any company, fund, or advisory firm named in this article. This article is for educational purposes only and does not constitute investment or legal advice.
Frequently Asked Questions
What does a quality of earnings report actually do that an audit does not?
An audit confirms financial statements conform to GAAP. A quality of earnings report stress-tests the EBITDA to determine how much of that earnings figure will still be there after the seller leaves. It reconciles reported EBITDA by removing one-time items, normalizing owner compensation, verifying revenue quality, and establishing a working capital target.
How much does a quality of earnings report cost, and when should it be commissioned?
For search fund acquisitions targeting businesses with $500,000 to $5M in EBITDA, QoE fees typically run $15,000 to $50,000. Commission it immediately after signing an LOI with exclusivity. Expect four to six weeks from engagement letter to final report, with weeks one through three covering document requests and fieldwork.
What are the five areas where a quality of earnings report can change the purchase price?
The five areas are owner compensation normalization, categorization of non-recurring items, revenue quality and customer concentration, working capital analysis, and tax or compliance exposure such as unregistered sales tax liability. The working capital peg established by the report can produce dollar-for-dollar purchase price reductions at closing if the seller delivers less than the agreed amount.
What options does a buyer have when the quality of earnings report surfaces material problems?
Three moves are available. First, reduce the purchase price to reflect the lower EBITDA at the agreed multiple. Second, restructure with a seller note tied to performance, converting a dispute into aligned incentives. Third, walk away from the deal entirely. Some problems, such as undisclosed litigation or customer contracts that terminate on change of control, are exit events rather than discounting events.
