SMB PE Expert Interviews: The Critical Role of Quality of Earnings for SMB Acquisitions
Chris Barrett
Why Quality of Earnings (QoE) Is Crucial for SMB Acquisitions
When acquiring a small or medium-sized business, a Quality of Earnings (QoE) report is essential. As explained by Chris Barrett of Midwest CPA, a QoE report analyzes the actual financial health of a business beyond surface-level numbers. It often corrects inflated EBITDA figures or misleading revenue.
This matters because small discrepancies in earnings can multiply into significant valuation differences. Buyers use QoE findings to make informed decisions and avoid costly overpayment.
Spotting Red Flags Before They Kill the Deal
A QoE report identifies adjustments that could disrupt a deal if uncovered late in the process. From inflated earnings to misclassified revenue, catching financial red flags early allows the buyer to renegotiate terms or choose to walk away confidently.
What a QoE Report Actually Covers
A QoE analysis includes several critical analyses:
Normalizing EBITDA to reflect the business’s true earnings potential
Evaluating working capital adequacy
Identifying debt-like liabilities
Ensuring accurate revenue recognition
Reviewing the accounting system and processes
Why Cash Accounting Can Be Misleading
Understanding the Deal Math: QoE and Purchase Price
How Normalized EBITDA Drives Valuation
Valuation is generally based on a multiple of EBITDA. However, this figure needs to be accurate and reflective of future performance. Sellers often include personal or one-time expenses in their EBITDA calculation. QoE reports strip those out to create a more realistic baseline for valuation.
Adjustments That Affect the Final Price
Every dollar adjusted in earnings can significantly impact purchase price. At a 4x multiple, a $25,000 correction changes the deal value by $100,000. These are not minor details but key variables that define your investment risk and return.
Working Capital: The Most Misunderstood Deal Component
How to Set a Working Capital Peg
Working capital is the money needed to keep the business running day to day. Chris advises calculating a peg using a 12-month average. This provides a stable benchmark and helps both parties agree on what should remain in the business post-close.
Why Misalignment Here Kills Deals
Misunderstandings around working capital expectations can derail transactions. A buyer may assume $500,000 will stay in the business, while the seller plans to withdraw that amount. Without clarity early on, this misalignment leads to friction and failed negotiations.
When Should Buyers Bring in a CPA?
Pre-LOI vs. Post-LOI Strategy
Although most QoE work happens after the Letter of Intent (LOI) is signed, Chris suggests involving a CPA earlier in the process. A CPA can help buyers estimate working capital needs, assess seller add-backs, and prepare a smarter, more defensible offer.
The Ideal QoE Timeline and Milestones
Once under LOI, the QoE process typically takes three to four weeks. The timeline depends heavily on the seller’s responsiveness. Early engagement with your CPA ensures fewer delays and a more confident close.
What Sellers Often Get Wrong (And What Buyers Miss)
Personal Expenses and Owner Adjustments
It’s common for sellers to run personal expenses through the business. From car leases to family vacations, these reduce reported income. A QoE report adjusts for such expenses, giving the buyer a clearer picture of the business’s real earning power.
Revenue Timing and Misclassification of Loans
Revenue recognition is another common problem. Loans, deposits, or customer prepayments are sometimes booked as income. These errors mislead both buyers and lenders. A QoE report corrects this and presents reliable numbers.
Protecting the Buyer-Seller Relationship During Diligence
Let Your CPA Play the “Bad Cop”
Asking tough financial questions can strain buyer-seller relationships. Chris recommends letting the CPA handle this role. The buyer can stay focused on building rapport, while the CPA ensures accountability and transparency.
Keeping the Conversation Productive and Respectful
It’s important to approach sellers with empathy. Many have never gone through a transaction before. CPAs experienced in small business acquisitions can maintain professionalism while asking critical questions that protect the buyer.
Post-Close Support: Beyond the Quality of Earnings
Upgrading Financial Systems After the Deal Closes
Post-acquisition, most businesses need a cleanup and reset of their financial systems. Midwest CPA helps buyers implement accurate, streamlined processes that support future growth and compliance.
Bookkeeping, Tax Strategy, and Fractional CFO Services
Midwest CPA also provides ongoing services including:
- Monthly bookkeeping and reporting
- Annual tax preparation and planning
- Fractional CFO support for decision-making and cash flow optimization
Watch the Full Video Here
Summary Transcript
Dennis Unrein: Welcome to the show—today’s guest is Chris Barrett, founder of Midwest CPA, here to break down the accounting side of SMB acquisitions. From Quality of Earnings (QoE) to working capital and buyer pitfalls, this episode delivers practical insights for anyone buying a small business.
What is QoE and Why It Matters (00:00–02:00)
Chris Barrett: A Quality of Earnings report validates whether earnings are accurate and sustainable. It’s about determining the true economic EBITDA, accounting for owner adjustments, one-time events, and accounting inconsistencies—so buyers don’t overpay.
The Three Drivers of Purchase Price (02:00–04:00)
Chris outlines the components of a deal valuation:
Normalized EBITDA or Seller Discretionary Earnings
Valuation Multiple, shaped by business risk and industry trends
Liabilities and Working Capital, often misunderstood but essential to deal structure
Financial Red Flags in SMB Deals (04:00–06:30)
Revenue recognition errors in cash-basis businesses
Misclassified loans reported as income
Owner expenses running through business books
Chris recalls a deal where a $100K cash advance was mistakenly booked as revenue, affecting both taxes and valuation.
Working Capital: Most Frequent Deal Killer (06:30–09:00)
Buyers expect a working capital buffer; sellers often plan to withdraw it. Misaligned assumptions can derail deals. Chris stresses setting a working capital peg in the LOI based on historical averages and business seasonality.
Avoiding Buyer Mistakes (09:00–12:00)
When to Hire a CPA and What They’ll Need (12:00–14:00)
- Post-LOI is the ideal time to engage a CPA for QoE. Expect to provide:
Monthly financials for 3 years
Bank and tax documents
General ledger access
Payroll and AR/AP summaries
QuickBooks access can dramatically streamline this process.
Post-Close Accounting Support (14:00–16:00)
Midwest CPA offers ongoing services:
Bookkeeping system upgrades
Tax planning and compliance
Fractional CFO support for financial strategy and growth
Chris Barrett’s Journey to Midwest CPA (16:00–End)
FAQs: Quality of Earnings for SMB Acquisitions
Order it shortly after signing an LOI. It’s typically the first step in diligence.
Costs range widely. Checkout our pricing page for more details!
It’s not required but is highly recommended, especially to validate earnings for lenders.
Buyers can renegotiate the price or back out of the deal with minimal loss.
Disclaimer
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.
