Most first-time buyers treat a quality of earnings report like a luxury. Something the big PE firms do on $50M deals. Not something a person buying a $2M landscaping business needs to worry about.
That thinking has killed more deals than bad due diligence ever has.
Here is the reality: a quality of earnings report is not about being thorough for thoroughness’s sake. It is about finding out whether the number the seller gave you is actually real. And in SBA-financed acquisitions, where your personal guarantee is on the line and your DSCR has to clear a hard threshold, that question carries weight you cannot afford to ignore.
What a Quality of Earnings Report Actually Is
A quality of earnings report, often shortened to QofE, is a financial analysis performed by an independent CPA or accounting firm. Its purpose is to verify the true earnings of a business you are considering acquiring.
It is not the same as an audit. An audit confirms that financial statements follow accounting rules. A QofE asks a fundamentally different question: does the cash flow number the seller is claiming actually reflect what a new owner will take home?
The QofE team digs into tax returns, bank statements, P&Ls, and general ledger entries. They identify add-backs that are legitimate, add-backs that are questionable, one-time revenues that should not be in the run-rate, and expenses that are suspiciously absent from the books. The output is an adjusted EBITDA or seller’s discretionary earnings (SDE) figure that has been independently verified. If you are unfamiliar with why that distinction matters, just know this: SDE is the number that drives your valuation multiple, your loan approval, and ultimately your purchase price. Getting it wrong cascades through everything.
On a $2M deal, the difference between a seller’s claimed SDE and the verified SDE can easily be $100K to $200K. That is not a rounding error. That is the difference between a deal that works and one that quietly drowns you in year one.
When You Should Get One
The short answer: any deal over $750K in purchase price warrants serious consideration.
But the short answer deserves some nuance.
For deals under $500K, a lighter-touch financial review often suffices. You are looking at 3 years of tax returns, bank statements, and a manual reconciliation of the stated SDE against what the bank accounts actually show. This is not ideal, but the economics of paying $15K to $25K for a full QofE on a $400K deal are hard to justify. You would be spending 4% to 6% of the purchase price on one piece of due diligence.
For deals in the $500K to $1.5M range, the decision depends on complexity. A straightforward business with clean books, consistent revenues, and uncomplicated add-backs may not need a full QofE. A business with multiple revenue streams, owner-reported cash income, or aggressive add-backs almost certainly does. We have seen deals in this range where the QofE knocked $150K off the defensible valuation. On a $900K acquisition, that changes everything.
For deals above $1.5M, get the QofE. The cost of the report is roughly 0.5% to 1% of deal size. The cost of overpaying by 10% on a $2M acquisition because the earnings were inflated is $200K. The math is the math.
How a QofE Affects Your SBA Loan
This is the part most buyers do not think through.
SBA 7(a) lenders underwrite to SDE or adjusted EBITDA, depending on the deal structure. They use that number to calculate your debt service coverage ratio (DSCR). We target a minimum 2.0x DSCR on acquisitions. Lenders generally want to see at least 1.25x, though anything below 1.5x should make you uncomfortable.
If the seller’s claimed SDE is $400K but the QofE comes back at $310K, your DSCR drops. Potentially below the threshold that makes the deal financeable at the price you negotiated.
Here is a concrete example. Say you signed an LOI for a $1.8M acquisition based on $400K SDE at a 4.5x multiple. At that price, your annual debt service on an SBA loan runs roughly $210K per year. Your DSCR on $400K SDE is 1.9x. Manageable.
Now the QofE comes back at $310K. DSCR drops to 1.47x.
That deal now requires a price reduction, better loan terms, or a larger seller note to work. But here is the thing: the QofE just handed you a negotiating argument worth hundreds of thousands of dollars. You are not guessing that the price is too high. You have a third-party report that proves it.
We have watched this play out dozens of times. The QofE does not kill deals. It kills bad deals, or it restructures deals into ones that actually make financial sense for the buyer.
What the QofE Team Will Actually Examine
Revenue quality is the first thing any good QofE firm looks at. They want to see customer concentration (one customer representing 30% or more of revenue is a red flag that should concern you and will absolutely concern your lender), non-recurring revenues that the seller has baked into the run-rate, and any revenues that are contractually uncertain post-close. A business that lost a major contract three months before listing but still shows that revenue in its trailing twelve months is a problem the QofE will catch.
Add-back scrutiny is where the real work happens. Sellers and their brokers add back personal expenses, one-time costs, and above-market owner compensation to inflate SDE. Some of these add-backs are legitimate. Others are not even close. A QofE separates them systematically, with documentation backing every adjustment.
Side note: this is also where proof of cash becomes critical. If the add-backs do not tie to what actually moved through the bank accounts, the seller’s SDE number is fiction. A good QofE firm will run that reconciliation as part of their standard process.
Working capital normalization often gets overlooked by buyers who are focused on the headline earnings number. If the business is seasonal or has unusual inventory cycles, the amount of working capital included in the deal matters significantly. The QofE will flag whether the working capital assumptions in the purchase agreement are realistic or whether you are going to need an additional cash infusion right after closing.
The report will also flag deferred maintenance, pending liabilities, and any off-balance-sheet obligations that should factor into valuation. These are the items that do not show up in a seller’s CIM but absolutely show up in your first year of ownership.
The Seller Note Angle
On most of the SBA deals we run, we target a 10-year full standby seller note at 0% interest. We achieve that structure on over 90% of our deals.
That seller note structure matters here for a reason beyond financing mechanics: it aligns the seller’s interest with the accuracy of the numbers they provided.
If a seller accepts a $200K seller note with standby provisions and it later turns out the earnings were materially misrepresented, they still have skin in the game. That is a meaningful incentive for accuracy. But skin in the game is not the same as verified accuracy.
The QofE is the verification mechanism. The seller note is the backstop. You need both.
All of That Covers the Upside of Getting a QofE. Now Consider What Happens Without One.
Buyers who skip the QofE on deals they should not have tend to discover the earnings problem one of three ways.
First, the lender’s own underwriting flags the discrepancy. SBA lenders do their own analysis, and if something does not reconcile between the tax returns and the broker’s stated SDE, they will ask questions. At that point, you are 60 days into a deal. You have spent money on legal and appraisals. And now you are scrambling to renegotiate from a weaker position than if you had caught it yourself.
Second, you close the deal and find out in year one. Revenue is lower than projected. Expenses are higher than the seller’s books suggested. The SDE you underwrote against does not materialize. You are now servicing debt you cannot comfortably cover, and your DSCR in practice is well below what the lender modeled.
Third, you find out during a future sale. If you ever go to sell the business, the buyer’s QofE team finds the same problems that were always there. Now they are your problems on the sell side, and they are going to cost you on valuation.
None of these outcomes are theoretical.
Framing the Cost Correctly
A quality of earnings report from a reputable firm runs $10,000 to $25,000 depending on the size and complexity of the deal.
That sounds like a lot.
It is not.
You are about to put 10% equity injection into an SBA deal. On a $1.5M acquisition, that is $150K of your own money going in at close, give or take. You are also personally guaranteeing an SBA loan that will likely be in the neighborhood of $1.3M to $1.4M (and yes, that includes your house if you have one with equity).
Spending $15K to verify the number that justifies that personal guarantee is the minimum rational due diligence for a transaction of this size. Not a luxury. Not optional on any deal of real substance.
If the QofE finds nothing wrong, you close with confidence. If it finds $150K in unsupported add-backs, you either renegotiate or walk. Either way, you made a better decision than you would have made without it.
For more on how SBA underwriting works and what lenders actually look for before approving your deal, see our breakdown of SBA 7(a) acquisition financing.
Can You Just Review the Tax Returns Yourself?
You can. And you should, regardless of whether you also get a QofE.
But reviewing tax returns yourself does not replace a quality of earnings report. Tax returns show reported income, not adjusted SDE with add-backs analyzed. Sellers frequently include add-backs that inflate the earnings figure well beyond what the returns show. Without a professional analysis of those specific add-backs, you are making a decision worth more than a million dollars with incomplete information.
Three years of tax returns. Minimum. That is your starting point, not your finish line.
For guidance on structuring due diligence before your LOI, our due diligence framework article covers the full process from internal review through third-party verification.
Frequently Asked Questions
Do I need a quality of earnings report for an SBA 7(a) acquisition?
SBA lenders do not formally require a QofE, but they conduct their own financial analysis of the business. If you skip the QofE, you are relying entirely on the lender’s underwriting to catch earnings discrepancies. That is a risky position for a buyer who is personally guaranteeing the loan. On any deal above $750K, getting your own QofE is strongly advisable before you are deep into the loan process.
How long does a quality of earnings report take?
A standard QofE takes 3 to 6 weeks depending on complexity and how quickly the seller provides financial documentation. Build this timeline into your LOI exclusivity period. Most LOIs grant 60 to 90 days of exclusivity, which is enough time if you engage the QofE firm immediately after signing.
Who pays for the quality of earnings report?
The buyer pays in most small business acquisitions. Costs typically range from $10,000 to $25,000. On larger or more complex deals, buyers occasionally negotiate for the seller to contribute to due diligence costs, but this is uncommon in SBA transactions. Factor the QofE cost into your total transaction budget from the beginning.
What is the difference between a QofE and an audit?
An audit verifies that financial statements comply with accounting standards like GAAP. A quality of earnings report goes further: it verifies whether the adjusted earnings figure the seller is presenting is actually sustainable and accurate for a new owner going forward. For acquisition purposes, the QofE is more directly relevant because it focuses on the specific number driving your valuation and financing.
Can I skip the QofE and just review the tax returns myself?
You can review tax returns yourself, and you should as part of your own internal diligence. But it does not replace a QofE. Tax returns show reported income, not adjusted SDE with add-backs scrutinized. Sellers frequently include add-backs that inflate the earnings figure beyond what the returns support. Without professional analysis, you are making a multimillion-dollar decision on incomplete information.
Working Through Your First Acquisition
Regalis Capital runs a done-for-you acquisition advisory service. We find deals, underwrite the numbers, coordinate quality of earnings review, structure the seller note, and manage the full SBA process from LOI to close.
If you are serious about acquiring a business and want a team that works through this process every day, start here.