A broker's add-back schedule tested line by line, the break-even finding, and what the report does to the price and the loan.
A quality of earnings report pays for itself when the SDE it removes, times the multiple you are paying, exceeds its fee. At an illustrative 3.0 times SDE and a 30,000 fee, it breaks even on finding 10,000 of overstated earnings, 1.25 per cent of 800,000. In the worked case below it finds 83,000, cutting the justified price by 249,000, 8.3 times its cost.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Buyers weigh the fee against the deal and see a small business that seems too small for a forensic review. The comparison is wrong. The fee should be weighed against the multiple: every dollar of earnings the seller's add-backs overstate is bought several times over, and is then also borrowed against.
| Input | Value |
|---|---|
| Broker's seller's discretionary earnings (SDE) | 800,000 |
| Multiple of SDE | 3.0x |
| Asking price | 2,400,000 |
| Quality of earnings fee (illustrative) | 30,000 |
| Loan: share of price, rate, term | 80%, 10.5%, 10 years |
| Market salary for a manager to replace the owner | 150,000 |
Step 1: break-even. The report is worth commissioning if the overstatement it is likely to find, times the multiple, exceeds the fee.
Break-even SDE overstatement = fee / multiple = 30,000 / 3.0 = 10,000, or 1.25% of SDE
Step 2: test each add-back against evidence. The reviewer ties the add-backs to ledgers, payroll and bank statements and asks one question of each: would this cost disappear under a new owner?
| Item | Claimed | Supported | SDE effect | Price effect at 3.0x |
|---|---|---|---|---|
| Owner's vehicle and phone (part business use) | 18,000 | 12,000 | −6,000 | −18,000 |
| One-time legal settlement (recurs every year) | 25,000 | 0 | −25,000 | −75,000 |
| Spouse on payroll (role must be refilled) | 40,000 | 8,000 | −32,000 | −96,000 |
| Year-end revenue booked early | 0 | −15,000 | −15,000 | −45,000 |
| Owner's travel (part is sales conferences) | 14,000 | 9,000 | −5,000 | −15,000 |
| Total | 97,000 | 14,000 | −83,000 | −249,000 |
None of these requires fraud. The settlement is "one-time" in each year's tax return but appears in all three. The spouse's salary is real, but the work it pays for still has to be done. The early revenue is a cut-off issue that only a month-by-month review finds.
Step 3: reprice.
Adjusted SDE = 800,000 − 83,000 = 717,000 (10.4% lower)
Price at 3.0x = 2,151,000; reduction = 249,000 = 8.3 × the fee
In Excel, with claimed add-backs in B and supported in C: =(SUM(C:C)-SUM(B:B))*Multiple-Fee gives the net value of the review.
The report earns 8.3 times its fee in this case. Even if a buyer thought there was only a 25 per cent chance of finding anything like it, the expected value would still be 32,250 positive; the review pays at any probability above 12.0 per cent of a finding this size.
The debt makes the case stronger. At the asking price the loan is 1,920,000 and annual debt service 310,890. On broker SDE less a 150,000 manager's salary, 650,000, coverage looks like 2.09 times. On the true 567,000 it is 1.82 times, before capital expenditure and tax. Repriced at 2,151,000, the smaller loan restores coverage to 2.03 times. The QoE fee buys a lower price and a loan the business can actually carry.
| Multiple | 5,000 found | 10,000 found | 25,000 found | 50,000 found | 83,000 found |
|---|---|---|---|---|---|
| 2.5x | −17,500 | −5,000 | 32,500 | 95,000 | 177,500 |
| 3.0x | −15,000 | 0 | 45,000 | 120,000 | 219,000 |
| 3.5x | −12,500 | 5,000 | 57,500 | 145,000 | 260,500 |
The fee matters less than its size suggests. A 15,000 review breaks even at 5,000 of SDE; a 50,000 review at 16,667. On a business with 800,000 of SDE and add-backs of 97,000, a review that cannot find 10,000, 1.25 per cent of SDE, is the exception, not the base case. The report is hard to justify only when add-backs are few, small and already documented, which is also when a broker rarely needs them to reach the asking price.
A QoE is not an audit. It does not opine on the accounts; it tests whether the earnings the price is built on will recur. Ask for the adjustment schedule, not only the summary.
How the adjusted SDE then turns into a price is shown in how to value a small business on a multiple of SDE, and why the owner's replacement salary matters to that SDE in how to convert SDE to EBITDA.
Divide the fee by the multiple to find the break-even finding, 10,000 here, then judge whether the add-backs leave room for it. In this case they left room for 83,000 and a 249,000 lower price. The free workbooks for this book carry the bridge from broker SDE to adjusted EBITDA, broker against quality of earnings, line by line.
Fees vary with the size and complexity of the business and the provider, so get quotes. What matters is the ratio to the multiple: at 3.0 times SDE, a 15,000 review breaks even on finding 5,000 of overstated earnings, a 30,000 review on 10,000 and a 50,000 review on 16,667.
Mostly add-backs that will not disappear under a new owner and revenue booked in the wrong period. In the illustrative case, 97,000 of broker add-backs are supported at only 29,000 and early revenue removes 15,000 more, cutting SDE by 83,000, or 10.4 per cent.
It changes what the business can carry. In the illustrative case, broker SDE less a 150,000 manager's salary covers debt service 2.09 times at the asking price; the true figure is 1.82 times. Repricing to 2,151,000 shrinks the loan and restores coverage to 2.03 times, before capex and tax.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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