Every business for sale comes with a number. Usually it's based on the seller's discretionary earnings (SDE) or adjusted EBITDA, and it sits on page one of the Confidential Information Memorandum (CIM). On average, actual purchase prices for small businesses will be 2-4x the SDE/EBITDA.
That number decides the price you pay, the loan you get, and whether the business can service the debt. It was also prepared by the seller and their broker, whose job is to get you to sign.
A quality of earnings report is how you find out what the business actually earns.
We bought our own firm with with an SBA 7(a) loan. Now we spend our days inside the books of Bay Area businesses. This is what we think potential buyers should understand before they rely on anyone's earnings number.
What is a quality of earnings report?
A quality of earnings (QoE) report is an independent analysis of a business's historical earnings. It answers one question: are the earnings real, recurring, and transferable to a new owner?
It does this by:
- Tying reported revenue and expenses back to bank statements and tax returns (often called a "proof of cash")
- Testing every addback and adjustment the seller claims
- Converting cash-basis numbers to accrual so revenue and expenses land in the right period
- Reviewing revenue quality: recurring vs. one-time, customer concentration, contract terms
- Analyzing working capital to set what the business needs to operate on day one
The output is an adjusted earnings figure that has been tested, not just asserted.
QoE vs. audit vs. CIM
These three documents get confused often, but they do different jobs. It's good to be aware of their purposes.
| CIM | Audit | Quality of Earnings | |
| Purpose | Market the business | Opinion on financial statement accuracy | Test sustainable, transferable earnings |
| Prepared by | Seller / broker | CPA | Financial professional |
| Focus | Adjusted earnings, growth story | GAAP compliance | Normalized earnings and cash |
| Tests addbacks? | No | No | Yes |
| Useful for pricing? | Starting point | Limited | Directly |
An audit tells you whether the financial statements follow accounting rules. A QoE tells you whether the earnings will still be there after you own the business. For a buyer, the second question matters more.
Do you need a quality of earnings report for an SBA loan?
For larger deals, yes, and that's new.
Under SBA SOP 50 10 8.1, effective October 1, 2026:
- A QoE is required for change-of-ownership acquisitions with a purchase price of $3 million or more. That's measured before buyer equity or seller financing and excludes owner-occupied real estate.
- It applies to initial acquisitions and business expansions. Partner buyouts, ESOPs and cooperatives are exempt.
- It must be prepared by an independent, experienced financial professional engaged for the lender's benefit, not by the buyer or seller.
- It must include a proof of cash covering the trailing twelve months and two fiscal years, documentation of all addbacks, and a revenue quality review.
- The lender must use QoE-derived earnings to calculate debt service coverage. The CIM number no longer drives underwriting.
The SOP also requires independent business valuations on all change-of-ownership deals. It keeps minimum DSCR at 1.25x for initial acquisitions, and post-close projections can't be used to meet that floor.
Below $3 million, a QoE is at the lender's discretion. We'd still recommend one, or at least a scoped-down version. Smaller businesses tend to have messier books, more owner-dependent revenue and more aggressive addbacks, which is exactly where a QoE earns its fee.
Where seller earnings usually break
This is the core of it. After looking at a lot of small business books, these are the places where the CIM number and reality tend to separate.
1. Addbacks that aren't one-time
The CIM adds back "non-recurring" expenses, but some recur every year under a different name: a legal matter one year, a system migration the next, a "one-time" bonus that gets paid every December.
Ask: Show me this expense category for the last three to five years.
2. Owner compensation that has to be replaced
Adding back the owner's salary is standard. But if the owner does real work (sales, operations, managing key clients), someone has to do it after close. In the Bay Area, replacing a working owner with a GM or controller is not cheap.
Ask: What does the owner actually do each week, and what would it cost to hire for it?
3. Family and unpaid labor
The spouse who does the books for free. The relative on payroll who does nothing. Both distort earnings in opposite directions, and only one of them usually gets adjusted.
Ask: Who works here, what do they do, and what are they paid vs. market?
4. Cash-basis timing
Many small businesses keep cash-basis books. Annual prepayments land as current-year revenue. Expenses get paid early or late depending on the owner's tax planning. A strong trailing twelve months can simply be a timing effect.
Ask: What does deferred revenue look like, and when were the large payments received vs. earned?
5. Revenue quality and concentration
Not all revenue is equal. Recurring revenue under contract is worth more than project work on a handshake. If one client is 20% or more of revenue, the risk profile changes, especially if that client's relationship belongs to the owner and not the business.
Ask: Revenue by customer, by type, for three years. Which relationships are documented in contracts?
6. Pricing and margin drift
This one is easy to miss. A business can look profitable while its pricing has been flat for years and the work behind each fee has quietly grown. Nothing looks wrong until the new owner tries to scale and finds that the margins were held up by the seller's own unpaid hours.
Ask: When were prices last raised? Are there clients where the effort consistently exceeds the fee?
7. Working capital
Receivables that will never be collected. Payables stretched before the sale. Inventory that doesn't move. The QoE should establish a normal level of working capital, and that becomes the peg at closing.
Ask: AR aging by customer, and what's the average working capital over the last twelve months?
What the gap does to your deal
A worked example (illustrative numbers):
- The CIM shows $600K adjusted EBITDA. The asking price is 4x, or $2.4M.
- With 90% financed on a 10-year term at roughly 10%, annual debt service is about $346K.
- DSCR on the CIM number: 1.73x. That looks comfortable.
Now the QoE finds:
- $40K of recurring "one-time" expenses
- $30K of revenue pulled forward on a cash basis
- $55K to replace unpaid family labor
Adjusted EBITDA drops to $475K. DSCR falls to 1.37x.
Two things just happened:
- Your headroom above the 1.25x floor went from 0.48 to 0.12. One bad quarter or one lost client puts you in covenant trouble.
- At 4x, the $125K gap is $500K of purchase price with no earnings behind it.
And under the new SOP, the lender underwrites to $475K, not $600K. Better to find that out before your LOI terms are locked.
What a QoE won't tell you
A QoE tests history. It doesn't underwrite the future, and it won't fully capture:
- Processes that live in one employee's head
- Staff likely to leave after the transition
- Outdated systems that will need replacing in year one
- How clients feel about the owner leaving
Those need operational diligence alongside the QoE. We learned this firsthand: the earnings question and the operating question are separate, and both matter.
How much does a quality of earnings report cost?
Pricing varies with deal size, the quality of the seller's books, and scope. Typical ranges:
- Under $1M purchase price: roughly $5K to $15K
- $1M to $5M: roughly $15K to $50K
- $5M to $25M: roughly $30K to $100K
A full QoE usually takes 30 to 60 days. The biggest driver of both cost and timeline is the state of the seller's books. Disorganized records mean more reconstruction work.
For smaller deals, a "QoE lite" focused on earnings adjustments, AR aging report, and proof of cash can cover most of the risk at a lower cost.
What to do if the QoE comes in low
A low QoE isn't a reason to walk away automatically. You can use it as leverage to negotiate.
- Renegotiate price to match verified earnings
- Restructure with an escrow holdback or seller note (SBA rules restrict how seller notes count toward equity and prohibit earnouts on 7(a) change-of-ownership deals, so confirm structure with your lender early)
- Re-run your DSCR on the QoE number, not the CIM number
- Walk if the gap reveals the business can't safely carry the debt
Remember that an SBA loan comes with a personal guarantee. A default isn't just a business problem, it's yours personally. Size the deal to the verified earnings.
Before you sign an LOI
You don't need to wait for the lender's QoE to start testing the numbers. Before LOI, you can:
- Request three years of tax returns, bank statements and P&Ls
- Tie tax return revenue to the CIM
- List every addback and ask for support
- Run your DSCR on a conservative case, not the broker's
Run your deal through our SBA Buyer's DSCR Stress Test using your own adjusted numbers. See how much cushion you really have.
How SVAS helps buyers
We're an outsourced accounting and controllership firm in Santa Clara, and we've been on the buy side of an SBA acquisition ourselves. We help buyers:
- Rebuild the seller's P&L before LOI so you know where the risk is
- Prepare for lender diligence and the QoE process
- Set up clean, accrual-basis books and monthly close from day one after closing, so your lender reporting and covenants are never a scramble
Talk to us about your deal!
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