Due Diligence and Quality of Earnings: What Buyers Will Examine

Owners tend to think of the letter of intent as the moment the price is set. In practice, the LOI sets a headline number that rests on assumptions: that reported earnings are real and repeatable, that the balance sheet delivered at closing will be normal, that there are no liabilities the buyer has not priced, and that the business will keep performing while it is being examined. Due diligence is the process of testing those assumptions. Where they fail, the price moves, the terms tighten, or the deal ends.

This guide explains what buyers examine, who does the work, what a quality of earnings (QoE) report contains, how adjusted EBITDA is rebuilt, and how working capital and debt-like items are negotiated. It closes with practical advice on running a data room and keeping the business on plan while diligence runs. It is written for founders, family owners and CFOs of lower middle market companies, but the mechanics apply to most private company transactions in the US.

When diligence happens and what it is for

Diligence happens in two stages. Before the LOI, buyers do preliminary diligence from the confidential information memorandum, a management presentation and a limited set of financial data. Its purpose is to decide whether to bid and at what value. After the LOI is signed and the buyer is granted exclusivity, confirmatory diligence begins. This is the expensive, detailed phase: the buyer engages accountants, lawyers and specialist advisors, and their lenders and insurers start their own reviews.

Confirmatory diligence typically takes 45 to 90 days for a lower middle market company, sometimes longer when there are multiple locations, regulatory licenses, international operations or carve-out complexity. During that period the seller has usually agreed not to talk to other buyers, which shifts negotiating leverage toward the buyer. That is the core reason preparation matters: every issue discovered during exclusivity is negotiated with fewer alternatives on the table.

The diligence workstreams

A financial buyer or a strategic acquirer will run several parallel workstreams. Smaller buyers combine some of them; larger sponsors and corporates staff each one separately. The financial and QoE workstream almost always drives price, but legal, tax and HR findings drive the purchase agreement: indemnities, escrows, special indemnities and closing conditions.

Representations and warranties (R&W) insurance has become common in lower middle market deals. It changes the shape of diligence rather than reducing it: the insurer underwrites the buyer’s diligence reports and typically excludes any area that was not diligenced, as well as known issues. A thin QoE or a skipped tax review can therefore leave the buyer uninsured on exactly the points that matter, and the buyer will push that risk back onto the seller through specific indemnities or escrows.

Quality of earnings: what the report contains

A quality of earnings report is not an audit. An audit expresses an opinion on whether financial statements are fairly presented under GAAP at a point in time. A QoE asks a commercial question: what is the sustainable, recurring earnings power of this business, and what balance sheet will the buyer actually receive? It is performed under agreed-upon procedures rather than auditing standards, and it focuses on the trailing twelve months (TTM) and the two prior fiscal years, sometimes with a review of the current-year forecast.

Buy-side versus sell-side QoE

A buy-side QoE is commissioned by the buyer after the LOI. Its scope and conclusions serve the buyer and its lenders, and its findings are the main source of post-LOI price adjustments. A sell-side QoE is commissioned by the seller before the business is marketed. It is shared with bidders, who typically still run their own buy-side review but use the sell-side report as a starting point and a reference for what has already been examined.

The main benefit of a sell-side QoE is control over timing. If the review finds that half of the proposed add-backs lack documentation, or that revenue recognition on long-term projects is inconsistent, the seller learns it while there is still time to correct records, restate adjusted EBITDA and set price expectations accordingly. The same finding discovered by a buyer during exclusivity becomes a price reduction proposed by a counterparty who knows the seller has stopped talking to everyone else.

Adjusted EBITDA: add-backs and how buyers treat them

Private companies are rarely run to maximize reported earnings. Owners pay themselves above or below market, run personal costs through the company, rent buildings they own to the business and absorb one-time costs that will not recur under new ownership. Adjusted EBITDA removes those items to show what the business would earn under normal, arm’s-length ownership. Buyers accept that adjustments are legitimate. What they do not accept is an adjustment without documentation, or one that removes a cost the business will in fact keep incurring.

Adjustments work in both directions. A diligence team will add back the owner’s excess salary, but it will also deduct for a controller who will need to be hired once the owner’s spouse stops doing the books for free, for bonuses that were earned but never accrued, and for below-market rent from a related party that will reset after closing.

A worked adjusted-EBITDA bridge

The following example shows a TTM bridge for a hypothetical distribution business with $48M of revenue. Management presented adjusted EBITDA of $7.52M in the marketing materials. The buyer’s QoE accepted most owner-related adjustments, trimmed several, rejected a pro forma price increase, and added four diligence adjustments that management had not considered.

Every add-back you claim will be tested against documents, not explanations.

Proof of cash and revenue recognition

A proof of cash reconciles what the accounting records say happened to what the bank statements show. In its fuller form, often called a four-way proof of cash, it reconciles opening cash, receipts, disbursements and closing cash between the general ledger and the bank for each month in the review period. The QoE team will also tie revenue to cash receipts after adjusting for changes in receivables, deferred revenue and customer deposits. Gaps can reflect timing, unrecorded transactions, cash collected for related entities, or revenue that was booked but never collected.

Revenue recognition is the other area where reported earnings most often move. Private companies frequently keep tax-basis or modified-cash books, and even accrual books may not follow ASC 606 consistently. Buyers look for:

• Cut-off: revenue recorded before goods ship or services are delivered, especially at month-end and year-end.
• Bill-and-hold arrangements where the customer has not taken control of the goods.
• Gross versus net presentation when the company acts as an agent rather than a principal, which inflates revenue without changing profit but distorts margins.
• Long-term projects recognized on billings rather than progress toward completion, creating over- or under-billings.
• Annual software or service contracts billed upfront and recognized immediately instead of over the service period.
• Customer rebates, volume discounts, returns and credits recorded when paid rather than accrued when earned.
• Cash-basis books that understate receivables, payables and accruals, which affects both EBITDA and working capital.

Revenue findings matter twice: once for EBITDA, and again for how buyers judge quality. Recurring, contracted revenue with low churn earns a higher multiple than project revenue that must be won again every year. The QoE’s revenue analysis by customer cohort, contract type and month is what supports or undercuts that story.

Net working capital and the peg

Most private company deals are priced on a cash-free, debt-free basis with a normal level of working capital. The seller keeps excess cash and pays off debt; in exchange the buyer expects to receive enough receivables, inventory and other current assets, net of payables and accruals, to run the business without injecting cash. The agreed normal level is the working capital target, or peg. At closing, and again in a true-up typically 60 to 120 days later, actual working capital is compared to the peg and the price is adjusted dollar for dollar.

The peg is usually set from an average of monthly net working capital over the trailing twelve months, adjusted for one-time items and, in seasonal businesses, for the expected closing month. Definitions matter as much as the number. Cash, funded debt, income taxes and transaction-related liabilities are typically excluded; items like customer deposits, deferred revenue and accrued bonuses can be argued into working capital or into net debt, and each choice moves money.

In this example the seller loses $600K at closing because receivables were collected faster and payables stretched in the final months, or simply because the business is seasonal and closing fell in a low month. Sellers who understand the mechanism avoid two common mistakes: stretching payables or accelerating collections before closing, which buyers will reverse, and accepting a peg built on a period that does not reflect seasonality.

Net debt and debt-like items

Enterprise value minus net debt equals the equity value the seller actually receives. Funded debt, such as bank loans and lines of credit, is uncontroversial. The negotiation is over debt-like items: obligations that are not labeled as debt but represent cash the buyer will have to pay for something that relates to the period before closing. Buyers’ QoE teams list these aggressively, and each one accepted reduces proceeds dollar for dollar.

Tax diligence and the California angle

Tax diligence looks backward at exposure and forward at structure. On exposure, the reviewers test whether federal, state and local income tax returns, payroll taxes, and sales and use taxes were filed and paid where they should have been. Since the Supreme Court’s 2018 decision in South Dakota v. Wayfair, states can impose sales tax collection obligations based on economic nexus rather than physical presence, and companies selling across state lines without registering in each state are a common source of findings. Thresholds and rules vary by state.

On structure, buyers often want a stepped-up tax basis in the assets they acquire, achieved through an asset purchase, a Section 338(h)(10) or 336(e) election, or an F reorganization of an S corporation. Each relies on the target’s tax history. An S corporation whose election was invalid, for example because of a second class of stock or an ineligible shareholder, can be treated as a C corporation, which can create corporate-level tax exposure and undermine the structure the buyer priced. Reviewers will request the election, shareholder history and distribution records to confirm it.

For California companies, buyers pay particular attention to employment exposure. California’s wage-and-hour rules, including meal and rest break requirements and overtime calculations, produce frequent class actions and claims under the Private Attorneys General Act (PAGA). Worker classification under the ABC test adopted in AB 5 is another recurring issue for businesses that rely on independent contractors. These findings rarely kill deals, but they often lead to special indemnities or escrows.

How to run a data room

A virtual data room is where diligence happens. Its organization signals how the business is run. A well-indexed room with complete, current documents shortens diligence and reduces the number of questions; a disorganized one invites more requests, slows the buyer’s advisors and increases the chance that something important is found late. Build it before marketing, populate it in stages, and track who has seen what.

• Stage disclosure. Release competitively sensitive material, such as customer names, pricing and employee compensation, only after the LOI and, for the most sensitive items, close to signing or to a clean team.
• Use one Q&A tracker. Every question gets a number, an owner, a due date and a written answer. Verbal answers create inconsistencies that surface later in the purchase agreement.
• Keep documents current. Upload monthly financials as soon as they close. Stale numbers prompt questions about why they are stale.
• Mirror the room in the disclosure schedules. What is disclosed in the data room becomes the basis for exceptions to the seller’s representations, so completeness protects the seller.

Diligence fatigue and keeping the business running

Confirmatory diligence routinely generates several hundred requests. The burden falls on a small number of people, usually the owner, the CFO or controller and one or two operating leaders, who also have to run the business. Diligence fatigue sets in around week six: responses slow, answers become less precise, and frustration leaks into negotiations. Meanwhile the buyer is watching monthly results. A missed month during exclusivity is one of the most common reasons a price gets reopened.

1. Form a small internal deal team of three to five people who know about the transaction, with clear ownership of each data room folder.
2. Agree a response cadence with the buyer, such as weekly batches of questions and answers within an agreed number of business days, rather than a constant stream.
3. Let your advisors absorb the volume: your banker manages the tracker and pushes back on duplicate or out-of-scope requests; your accountant handles QoE fieldwork questions directly.
4. Protect the operating plan. Delegate day-to-day decisions, keep sales leaders focused on the pipeline, and avoid large discretionary changes that the buyer will ask about.
5. Plan employee and customer communications. Decide in advance who is told, when, and with what message, and control the timing of any buyer contact with customers or key staff.

Preparing before buyers arrive

The most effective diligence preparation happens six to twelve months before a process starts. Convert to accrual accounting if needed and close the books monthly within a few weeks. Document every add-back you intend to claim, with invoices and ledger detail. Reconcile revenue to bank deposits yourself. Identify debt-like items and decide how you will present them. Clean up corporate records, confirm IP assignments from employees and contractors, check state tax registrations, and gather customer and supplier contracts in one place. Consider a sell-side QoE once the books are in order.

None of this changes the underlying business, but it changes how much of the business’s value survives diligence. Buyers pay for certainty. A seller who can answer the hard questions with documents before they are asked gives the buyer fewer reasons to reprice and more reasons to close on schedule.

How Laurent Capital helps

Laurent Capital advises lower middle market business owners on sell-side processes from preparation through closing. We help clients scope and coordinate sell-side quality of earnings work, pressure-test add-backs and working capital pegs before they reach buyers, build and manage the data room and Q&A process, and negotiate diligence findings so that management can stay focused on running the business.