What Is Quality of Earnings? | Agency M&A Definition
A quality of earnings (QoE) report is an independent financial analysis conducted during due diligence to verify that a company’s reported earnings are accurate, sustainable, and not inflated by accounting tricks, one-time events, or aggressive revenue recognition. It goes beyond a standard audit to assess whether the profits a buyer is paying for will actually continue after the acquisition.
Quality of Earnings in Agency M&A
Buyers acquiring a marketing agency increasingly commission quality of earnings reports, particularly for deals above $2 million. The QoE process involves a third-party accounting firm reviewing 2-3 years of financial statements, interviewing management, and stress-testing every revenue line and expense category. For agencies, the QoE analyst pays special attention to revenue recognition practices — specifically whether the agency recognizes retainer revenue when billed or when services are delivered, and how project revenue on long-term engagements is recorded. They also examine whether media spend that passes through the agency is being counted as revenue, which artificially inflates the top line without adding margin. Client concentration and revenue durability come under intense scrutiny: a QoE will flag if 25% of revenue comes from clients on month-to-month terms versus multi-year contracts. The report will also validate or challenge the seller’s proposed EBITDA add-backs, often reducing normalized earnings by 10-25% from what the seller initially presented. A QoE typically costs the buyer $25,000-$75,000 depending on deal size and agency complexity.
How Quality of Earnings Affects Agency Valuation
A quality of earnings report can make or break an agency deal. When the QoE confirms the seller’s financials, it builds buyer confidence and often accelerates closing. When it reveals problems, it triggers renegotiation or deal termination. In agency transactions, QoE findings that most commonly reduce purchase price include: overstated add-backs (reducing normalized EBITDA by 10-20%), pass-through revenue counted as agency revenue (which lowers true margins), and revenue from at-risk clients being treated as recurring. A QoE that reduces adjusted EBITDA from $700,000 to $580,000 at a 5.5x multiple wipes $660,000 off the deal value. Sellers who commission their own sell-side QoE before going to market spend $20,000-$40,000 but gain a significant advantage: they can address issues proactively, present pre-validated financials, and reduce the chance of a surprise re-trade during due diligence.
Example
A full-service marketing agency with reported revenue of $4.5 million and seller-stated adjusted EBITDA of $810,000 enters due diligence at a 6x multiple, implying a $4.86 million deal. The buyer commissions a QoE report for $45,000. The analysis finds three issues: (1) $380,000 in pass-through media spend was included in reported revenue, inflating the top line; (2) one add-back of $55,000 for ‘business development travel’ was actually recurring and should not be added back; and (3) a $120,000-per-year client had already given informal notice of departing. The QoE adjusts EBITDA down to $685,000. At 6x, the revised valuation is $4.11 million — a $750,000 reduction from the original asking price. The seller, who had not done a sell-side QoE, had no opportunity to address these issues before they became negotiating leverage for the buyer.
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