The Role of a Quality of Earnings (QoE) Review in M&A Transactions: Pros and Cons for Buyers and Sellers

During the M&A process, both buyers and sellers face critical decisions that impact valuation, negotiation dynamics, and overall deal success. One influential step in the process is a Quality of Earnings (QoE) review - an independent financial analysis that assesses the accuracy and reliability of a company's reported earnings before an M&A transaction.  It is designed to adjust prior earnings for one-time or unusual expenses or revenue and to estimate the sustainability or maintainability earnings post-close before synergies for the new owner.

Whether the seller funds the QoE analysis before initiating a competitive auction process with an M&A Advisor/Investment Bank or the buyer conducts it once a Letter of Intent (LOI) with an exclusivity period is agreed to by the seller, the decision to undertake such a review carries significant strategic implications. Let’s break down the pros and cons from both perspectives.

The Seller’s Perspective: Funding a QoE in Advance: Some sellers consider financing a QoE review before putting their business on the market, particularly if they have a lot of complexity in their corporate structure with inter-company transfers, complex risk management processes such as currency hedging from international business, or discretionary spending in the business. This proactive approach can be advantageous, particularly when preparing for a competitive auction process.

Pros:
Enhances Credibility & Transparency: A seller-funded QoE review provides potential buyers with 3rd party validated financial data, improving confidence in the numbers presented. This transparency often leads to stronger interest and higher bids.
Strengthens Negotiation Power: By addressing financial ambiguities before due diligence, sellers reduce the likelihood of unexpected adjustments or price reductions from buyers during the sale process. A well-structured QoE report enables sellers to justify expectations regarding valuation.
Speeds Up the M&A Process: Providing buyers with a comprehensive earnings analysis upfront streamlines due diligence and minimizes delays, as fewer financial surprises emerge post-offer.
Supports Higher Valuation: A thorough earnings analysis can highlight normalized earnings, adjust for one-time expenses, and correct financial misstatements. This can justify a premium price and reduce uncertainty-based discounts.

Cons:
Additional Cost Burden: Hiring an independent advisory firm to conduct the QoE review can be expensive, especially for small to mid-sized businesses. Some sellers may struggle with justifying the upfront investment.
May Reveal Unfavorable Financial Insights: A deep dive into financials might expose vulnerabilities, such as earnings volatility or non-recurring revenue streams that could weaken a seller’s position. While it's better to uncover these beforehand, it can be a challenging realization and, in some cases, may require some corrective actions prior to going to market.
Potential Redundant Buyer Review: Despite a seller-funded QoE, many buyers will still be required to commission their own financial assessment, particularly if they are publicly traded or PE-backed. This could lead to slight discrepancies between reports, potentially reigniting valuation debates.

The Buyer’s Perspective: Funding a QoE During Due Diligence: From the buyer’s perspective, conducting a QoE review as part of due diligence ensures they have a thorough understanding of the company’s financial health before closing the deal.

Pros:
Provides Independent Verification: A buyer-funded QoE review allows the acquiring party to validate earnings sustainability without full reliance on seller-provided financials. This reduces the risk of financial misrepresentation or non-GAAP/non IRFS accounting practices.  It provides a baseline for projected earnings post-close once potential synergies are layered on, such as cost savings, revenue enhancements, or operational efficiencies.  Once the baseline projection plus projected synergies is estimated, the buyer can model their pro forma financials to determine how aggressive they can be in the competitive bidding process and still meet their return on investment targets.
Enhances Bargaining Position: If the analysis uncovers inconsistencies, buyers can renegotiate deal terms or request price adjustments based on revised earnings calculations.
Mitigates Investment Risk: By scrutinizing financial metrics such as EBITDA adjustments, revenue quality, and working capital trends, buyers gain deeper insights into cash flow stability - critical for long-term success.
Tailored to Buyer’s Needs: Unlike a seller-sponsored review, a buyer-funded QoE focuses on factors most relevant to the acquirer’s investment strategy, helping inform integration planning and future financial forecasting.

Cons:
Time Constraints: Conducting a QoE review under an LOI framework requires swift action. If extensive issues arise, this could delay the closing timeline or even derail the transaction entirely.
Added Due Diligence Costs: Buyers must bear the expense of hiring financial experts, which, depending on deal size, may be a substantial cost burden: especially if multiple targets are being evaluated.
Risk of Seller Resistance: If discrepancies emerge between seller-reported financials and the buyer’s QoE findings, it can lead to tense negotiations. Some sellers might push back against material adjustments, resulting in drawn-out discussions.
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Conclusion
A QoE review is a powerful tool in M&A transactions, but the timing and funding source play a critical role in determining how it benefits each party. For sellers, proactively conducting the review enhances transparency, strengthens valuation claims, and streamlines deal execution, but comes with added costs and potential for exposing financial weaknesses. For buyers, an independent QoE assessment ensures reliability in reported earnings, supports risk mitigation, and aids negotiation leverage, though it extends due diligence timelines and incurs expenses.
Ultimately, a well-executed QoE review, whether initiated by the seller or buyer, can be the key to securing a fair, successful transaction with minimized surprises.

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