The Question Is Not Whether The Business Made Money.
The Question Is Whether Buyers Can Trust It.
Quality of earnings is how buyers determine whether the EBITDA number in the information memorandum reflects sustainable, repeatable business performance — or a collection of one-off tailwinds, accounting adjustments and founder-dependent activity that will not survive the ownership transition.
Quality of earnings is the buyer's test of whether reported earnings are as good as they appear.
A business with $4M EBITDA may actually be worth a very different amount depending on how that EBITDA was generated, how consistently it can be replicated, what proportion of it depends on conditions that will not persist post-sale, and how much of it requires the specific people, relationships and operational practices that currently exist in the business.
Quality of earnings analysis — typically conducted by the buyer's advisers in due diligence — works through each component of the reported EBITDA and assesses it against three tests. Sustainability: will this earnings component persist at the same level under new ownership and in the near-term market environment? Repeatability: is this earnings performance a function of a replicable commercial and operational process, or is it a one-off event that inflated a specific period? Transferability: does this earnings performance depend on people, relationships or practices that will not transfer with the business?
Founders frequently underestimate how much of their EBITDA will be questioned in a QoE process. Not because the business is performing poorly — but because the evidence base for the sustainability, repeatability and transferability of that performance has never needed to be made explicit in the context of the founder-led business. It becomes explicit for the first time in a transaction.
Will this earnings performance persist at the same level under new ownership, at current market conditions, without the current founder's involvement?
Is this earnings performance the product of a repeatable commercial and operational process? Or does it include one-off revenue events, cost recoveries, timing adjustments or favourable market conditions that will not recur?
Will the earnings performance transfer to the new ownership structure? Or does it depend on the founder's relationships, the founder's commercial instincts, or the founder's personal involvement in key operational processes?
The buyer doesn't pay for what the business earned last year. They pay for what it will earn next year, and the year after, under their ownership. Quality of earnings is the evidence base for that assessment.Transaction Architecture Doctrine — Shape Executive
Each dimension of earnings quality maps to a specific area of operational and commercial performance.
Revenue quality assesses whether the revenue base is recurring versus transactional, contracted versus discretionary, and growing through commercial discipline versus growing through favourable market conditions that may not persist. A business with $20M revenue that is 70% recurring, with average contract lengths of 3 years and a net revenue retention above 100%, has fundamentally higher revenue quality than a business with $20M revenue that is 80% transactional and dependent on current market pricing conditions.
Founder action: understand your revenue composition at a granular level and be able to explain what structural mechanisms produce recurring revenue — not just that it happens to recur. See: Revenue Quality vs Revenue Growth.
Customer concentration is both a revenue quality issue and a risk issue. A business where the top three customers represent 60% of revenue is a business where the loss of one relationship creates a material earnings event. Buyers discount for concentration — both in the multiple they will pay and in the terms they will require. The concentration discount is amplified when the concentrated customer relationships are founder-dependent.
The most important founder preparation work on customer concentration is not diversification — that takes years. It is making the customer relationships explicitly less dependent on the founder: ensuring senior leaders own the relationships, that there are multiple contact points in each key account, and that the relationship is documented and managed systematically rather than informally.
Margin quality examines whether the gross margin profile is reliable and replicable. Are margins consistent across the customer base? Is margin by product and customer visible and systematically managed? Are there specific pricing practices or cost structures in place that make the current margin sustainable — or does the margin depend on favourable commodity pricing, a single supplier relationship, or a pricing approach that has not been formalised?
A business with a documented pricing governance framework — where pricing decisions are made systematically rather than case-by-case — presents materially better margin quality evidence than a business where pricing is instinctive and undocumented.
Working capital quality assesses whether EBITDA converts to cash predictably and at the rate the financial model implies. Poor working capital quality is frequently hidden in businesses where cash conversion has been managed through the founder's personal involvement in collections, where inventory is carried at a level that does not reflect current demand, or where payment terms with customers or suppliers are at risk of changing post-sale.
The working capital peg — the normalised level of working capital that the business requires to operate — is one of the most contentious areas in any transaction. A business that can demonstrate consistent working capital management through a formal process rather than through founder involvement has a significant advantage in the working capital peg negotiation.
Forecast reliability is assessed by comparing historical forecasts against actual outcomes. A business that consistently forecasts within a narrow range of its actual performance is demonstrating management quality: the commercial and operational visibility required to predict business performance with confidence. A business where actuals frequently and materially deviate from forecasts — in either direction — is demonstrating a management information problem that buyers will factor into their risk assessment.
In industrial and distribution businesses, forecast reliability is primarily a function of commercial pipeline visibility and operational performance consistency. Both are solvable through process improvement — but the improvement takes time to evidence.
QoE analysis will identify and remove from EBITDA any earnings components that are not part of the run-rate business: one-off revenue events, insurance recoveries, government subsidies, cost savings from positions that have already been refilled, lease savings from properties that will return to market rate. Every normalisation reduces the EBITDA number that the multiple is applied to. The more one-off items that need to be normalised, the more the total enterprise value falls.
Founders should identify and document every potential normalisation item before going to market — not to hide them, but to understand the adjusted EBITDA number that will form the basis of negotiations and to avoid surprises in due diligence that create retrading risk.
The quality, timeliness and granularity of management reporting is itself a quality of earnings signal. A business that produces management accounts within 10 business days of month-end, with P&L by division, gross margin analysis and cash position, is signalling a management information capability that buyers associate with operational maturity. A business that takes 6 weeks to produce monthly accounts, with limited below-gross-profit detail, signals an information infrastructure problem that creates due diligence risk.
Management reporting quality is one of the areas where improvement has the highest return on investment in a pre-transaction preparation programme — because it is both directly evidenceable and immediately perceived as a signal of management competence.
Buyers conduct QoE analysis to find the adjustments that reduce the EBITDA number. The foundation of a strong due diligence outcome is not having nothing to find — every business has something to find. It is having documented, systematic evidence for every component of the EBITDA that shows it is sustainable, repeatable and transferable. The businesses that perform best in due diligence are the ones where the management team can walk buyers through the operational evidence for each earnings component with confidence and precision.
See: Operational Due Diligence Readiness — the operational layer of what buyers examine beyond the financials.
The window for improving earnings quality is measured in years, not months. The six months before going to market is too late.
Quality of earnings improvement is not primarily a financial or accounting exercise. It is an operational exercise. The financial outcomes — sustainable EBITDA, reliable cash conversion, consistent margins — are the product of the commercial and operational systems that generate them. Improving earnings quality means building those systems.
Pricing governance is the highest-return improvement investment for most industrial businesses. A formal pricing governance framework — where pricing decisions are made systematically, where margin by customer and product is visible, and where exceptions require documented approval — produces both direct margin improvement and a demonstrable evidence base for margin sustainability in due diligence.
Management reporting quality is the fastest to improve and the most immediately visible to buyers. Reducing the time from month-end to management accounts from six weeks to ten business days, while adding gross margin detail and operational KPIs, creates an evidence base for management competence that is directly observable in the due diligence process.
Customer relationship transferability is the most time-intensive to improve — and the one that matters most for founder-dependent businesses. The systematic transfer of key customer relationships from founder to senior commercial leaders requires time to execute without disrupting the relationships, and evidence of success (the relationships continuing to perform without the founder's direct involvement) requires at least 12 months to demonstrate convincingly.
The founder readiness preparation programme integrates quality of earnings improvement into the broader operational preparation for transaction — connecting the specific QoE improvements to the sell-side readiness framework that governs how the business presents itself to the market.
- Year 3+: build the operational systems that produce sustainable earnings
- Year 2: reduce founder dependency in key customer and operational roles
- Year 1: build the evidence base — reporting quality, pricing governance, forecast accuracy
- 6 months: prepare for the QoE process — know every normalisation item before buyers find it
Build The Earnings Quality
Before The Process Tests It
The founders who achieve the strongest transaction outcomes enter the process with three years of evidence that their earnings are sustainable, repeatable and transferable. That evidence is built through operational work, not transaction preparation.