You get a first call from a potential buyer. It goes well. Their adviser follows up with a list of due-diligence requests and mentions they will be looking at “quality of earnings.” You agree, hang up, and spend ten minutes wondering what that actually means.
Quality of earnings is one of those phrases that corporate finance advisers use freely, as if everyone in the room already knows it. This post explains what it means, where you will encounter it, and what a clean quality of earnings story looks like for a small UK service business.
What is quality of earnings?
Quality of earnings is a due-diligence exercise that tests whether a business’s reported profit is real, sustainable, and repeatable after the deal closes. An audit checks whether the financial statements are accurate under accounting standards. Quality of earnings goes further and asks a forward-looking question: will these earnings continue once the founder is no longer running the day-to-day?
The mechanism is normalisation. Buyers and their advisers start with the reported profit and make adjustments. They add back costs that will not recur after the sale, such as a one-off legal bill or a vehicle the founder runs through the company. They also remove benefits specific to the current ownership structure, such as a below-market salary the founder pays themselves. What remains is normalised EBITDA: the earnings the business would generate for a new owner on an arm’s-length basis.
Profitable UK service businesses are commonly priced on an earnings multiple. Advisers typically cite a range of three to eight times EBITDA for owner-managed firms, depending on risk profile and the quality of the earnings themselves. At the upper end, a buyer is paying a significant premium for something they believe will last. Quality of earnings is the exercise that tests whether that belief is warranted.
Why does quality of earnings matter for your business?
For owner-managed service firms, the central quality of earnings concern is founder dependency. If the business works well because the founder personally quotes, manages key accounts, and resolves escalations, a buyer is effectively buying a person as much as a company. That risk gets priced in. Buyers discount the earnings when they can see that a meaningful share of the profit will leave with the founder.
Two other areas come up regularly.
Recurring revenue, meaning subscriptions, retainers, repeat orders, and contracts with clear renewal terms, is easier for a buyer to underwrite than a stream of one-off projects. If a buyer has to rebuild the pipeline from scratch after the deal, that uncertainty is reflected in a lower multiple or a shorter earnout period. Showing that customers return reliably, and that the contracts are documented, makes the earnings easier to value.
Customer concentration is the other test. Advisers commonly cite 20% of revenue as a reference point, though it is not a formal threshold. A heavily concentrated revenue base creates fragility. If that customer leaves or renegotiates after the deal, the earnings the buyer paid for look very different.
Where will you actually meet it?
Quality of earnings comes up in two ways for a small business seller. The first is a buyer request during formal due diligence, when the buyer’s team works through a QoE analysis before signing. The second is a sell-side report the seller commissions before going to market, to surface issues early and hand buyers a validated set of numbers to work from.
A sell-side QoE typically covers three main areas: revenue recognition (how and when income is booked), expense patterns (whether costs are genuinely business-related and recurring), and working capital (how much cash the business needs to run month to month, and whether seasonal swings are unusual). Commissioning this before you have a buyer in the room means any problems surface on your terms rather than theirs.
Whatever route you take, you will need a clean data room. Buyers want to see contracts, invoices, payroll records, retention and churn data, and supplier terms. The sooner these are ready, the smoother the process.
If your service firm holds customer or employee personal data, sharing that information during due diligence falls under UK GDPR. The Information Commissioner’s Office publishes guidance on what a seller can lawfully disclose to a prospective buyer and on what basis. Thinking through this before you start handing over management information avoids a complication later.
When should you ask for a QoE report, and when can you skip it?
A sell-side quality of earnings report makes most sense when the deal is earnings-based and the buyer is sophisticated. In those circumstances, having your numbers independently validated reduces the risk of a price chip late in the process. If the numbers are contested, you have evidence. If they are clean, you have already done the buyer’s homework for them.
Three situations suggest a formal report is less necessary. The first is a very small or simple transaction where the accounts are clean, the profit story is obvious, and the buyer is not a financial sponsor. The second is an asset-based deal, where the buyer is paying primarily for equipment, a client book with assignable contracts, or property rather than for an earnings stream. The third, and most important to flag: if you plan to claim add-backs but cannot support them with invoices, payroll records, or board minutes, a QoE exercise can expose the uncertainty rather than resolve it. Unsupported adjustments rarely survive scrutiny.
One further consideration for regulated service businesses: if the firm holds an FCA authorisation or serves regulated companies in the UK, buyers will assess whether key services can continue without disruption when ownership changes. The FCA’s operational resilience framework is a live line of questioning in those deals, not a box-ticking exercise.
What else will you hear alongside quality of earnings?
Quality of earnings sits inside a wider set of deal terms that come up in any sale conversation. Knowing these concepts lets you follow the discussion and ask sharper questions of your advisers rather than relying on whoever is in the room to explain them. None require an accounting qualification to understand. They each describe a practical question the buyer is trying to answer.
Normalised EBITDA is what quality of earnings produces: earnings before interest, tax, depreciation, and amortisation, adjusted to remove one-offs and personal costs. It is the earnings figure buyers use when applying a multiple to set the initial offer price.
Seller’s discretionary earnings (SDE) is used more often in very small deals. SDE adds back the owner’s salary and personal benefits on top of EBITDA normalisation adjustments, giving a sense of the total cash the business generates for its owner. Where EBITDA is the metric for businesses with a management layer, SDE is the metric for businesses that run primarily through the founder.
An earnout is a deferred element of the purchase price tied to the business hitting performance targets after completion. Earnouts are common where there is genuine uncertainty about whether the earnings will hold after the sale. If your quality of earnings story relies partly on projected growth rather than demonstrated history, expect the buyer to include an earnout clause.
A working capital peg is a mechanism used in many deals that sets a target level of working capital at completion. If actual working capital is above or below the agreed figure, the price adjusts accordingly. How your working capital has moved over the past 12 months is part of what the QoE exercise covers, and part of what a data room should show clearly.
If the deal is part of a wider consolidation in your sector, it is worth knowing that the Competition and Markets Authority has jurisdiction to investigate mergers that cross certain thresholds. Your corporate finance adviser will flag if that applies, but it is a reason to understand the regulatory landscape before you are inside a live transaction.
A clean quality of earnings story does not happen in the last three months before a sale. It is built over time, by running the business in a way that is documented, delegated, and financially transparent. The earlier you start building that story, the more options you have when a buyer comes calling.
