When you move to acquire a mid-market enterprise, the seller will often present a “Sell-Side Quality of Earnings” (QofE) report. To an unsophisticated buyer, this looks like a clean bill of health. To a seasoned investor, it is the seller’s opening argument in a high-stakes negotiation.
A sell-side QofE is designed to “normalize” earnings—which is often a polite way of saying “inflating the EBITDA.” As a buyer, your objective is to deconstruct this narrative to find the Durable Earnings Power of the asset. You are not buying what the company was under the founder’s discretionary management; you are buying what it will be under your institutional stewardship.
The Anatomy of “Aggressive” Add-Backs
The delta between a company’s tax returns and its adjusted EBITDA is where the most significant valuation risks are hidden. We categorize these adjustments into three levels of scrutiny:
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Standard Adjustments (Low Risk): One-time legal fees, the owner’s personal vehicle lease, or a non-recurring equipment repair. These are generally acceptable.
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Operational Adjustments (Medium Risk): The “Market-Rate Salary” adjustment. If the founder is working 80 hours a week for a $100k salary, the seller will argue that is a “normal” expense. You must argue that replacing that founder requires a $250k CEO and a $150k COO. That $300k difference comes directly out of your EBITDA.
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Pro-Forma Adjustments (High Risk): “If we hadn’t lost that one client in Q2, our earnings would be $1M higher.” Sophisticated buyers reject “lost opportunity” add-backs. You pay for realized performance, not hypothetical recovery.
Spotting the “Revenue Mirage”
A QofE isn’t just about expenses; it’s about the integrity of the top line. During buy-side due diligence, we look for two specific red flags:
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Channel Stuffing: Did the company offer massive discounts in the final month of the fiscal year to pull future sales forward and hit a “record” EBITDA just before going to market?
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Revenue Recognition: Is the company booking the full value of a multi-year contract today, or are they spreading it out over the life of the service? If the cash hasn’t hit the bank, the “earnings” are merely an accounting opinion.
The Working Capital “Squeeze”
The final battlefield of the QofE is the Working Capital Peg. Sellers often try to strip the business of excess cash and inventory just before the close.
If the seller presents a “lean” working capital requirement, they are essentially asking you to fund the company’s operations with your own capital on Day 2. We utilize a 12-month rolling average to set the “Peg,” ensuring that the business arrives at the closing table with enough fuel in the tank to reach your growth objectives.
The Buy-Side Verdict
A David Mayfair buy-side review doesn’t take the seller’s QofE at face value. We look for the “Net Durable Cash Flow”—the money that remains after the founder’s ego and accounting tricks are removed. In M&A, you don’t get what you deserve; you get what you have the data to defend.
