Due Diligence & Quality of Earnings: Verifying What You're Buying

You have a signed letter of intent. The seller’s broker sent you a “normalized SDE” figure and a three-year summary P&L. The excitement is real. This is also the moment most buyers make the mistake that costs them everything: they take the seller’s numbers at face value instead of treating them as a starting point for investigation.

Due diligence is not a formality. It’s the process of verifying every claim the seller made — or implied — before your money leaves escrow. And at the center of it is the Quality of Earnings review: the forensic exercise that answers whether the profit number the seller quoted is the profit number you’ll actually inherit.

SDE Is a Claim, Not a Fact

When a listing says “$250,000 SDE,” that number has been assembled — sometimes carefully, sometimes aggressively — from the seller’s raw financials. SDE stands for Seller’s Discretionary Earnings, and the word “discretionary” matters more than most buyers realize. The seller has discretion over which expenses to add back, how to classify one-time costs, whether to include PPP-era revenue, and whether to report personal expenses as business costs.

EBITDA removes fewer variables (it doesn’t add back owner comp) but faces the same problem: the underlying data is supplied by the seller. Neither number is audited. Neither number is verified by a third party until you commission a QoE.

Your job in due diligence is to rebuild both numbers from the ground up using original source documents — tax returns, bank statements, merchant processor statements, payroll records, and lease agreements. Accept nothing the seller’s broker assembled without independent verification.

Legitimate Add-Backs

These are expenses that benefited the current owner but won’t transfer to you. They are standard and expected:

• Owner’s salary, payroll taxes, and benefits (health insurance, 401(k) contributions)
• Personal vehicle lease, personal travel, and meals labeled as business but clearly for the owner
• One-time legal settlements, non-recurring consultant fees, or a single branding/website rebuild
• Depreciation and amortization (non-cash charges)
• Interest expense on debt you’re not assuming
• Rent above or below market rate (if the seller owns the building and charges the business above-market rent, normalize to market)
• Family members on payroll who will not stay post-close

Red-Flag Add-Backs

Rebuilding Revenue From Source Documents

The P&L tells you what revenue was recorded. Bank statements tell you what revenue was deposited. Tax returns tell you what revenue was reported to the IRS. These three numbers should reconcile. When they don’t, you have a problem — and you need to know which direction the discrepancy runs.

The Bank-to-Books Reconciliation

For every month of the trailing twelve months, export the business bank statements as a CSV. Sum all deposits that could be customer revenue (exclude loans, owner capital injections, tax refunds). Compare the monthly deposit totals to the monthly revenue line on the P&L.

• If bank deposits consistently exceed reported revenue, the seller may be underreporting income to the IRS — which means the stated SDE is actually higher than what’s on the tax return (a messaging problem for you) or the business has cash revenue that isn’t tracked (a verification problem).
• If reported revenue consistently exceeds bank deposits, revenue may be overstated on the P&L — or the business uses multiple accounts you haven’t seen. Ask for all account statements.
• If deposits and reported revenue diverge in specific months but match in others, you’re looking at a timing issue (revenue recognition) or a one-time anomaly.

Revenue Recognition Gotchas

• Prepaid contracts booked as current revenue. If a customer paid $120k for a 12-month contract in December, only $10k belongs to that fiscal year. The remaining $110k is a liability (deferred revenue), not income. Aggressive sellers book the full amount.
• Related-party revenue. Sales to entities the seller also owns — a second LLC, a family member’s business, a joint venture — may not survive a change in ownership. Strip them out unless the contracts are assignable and arm’s-length verifiable.
• One-time contracts that closed the year. A business that did $500k in revenue for three years straight, then spiked to $700k because of a single government contract that ended, should be valued on $500k — not the spike year.
• Revenue booked but not collected. Check accounts receivable aging. If 40% of revenue is over 90 days outstanding, you’re buying a collection problem, not a business.

Customer & Supplier Concentration

Concentration risk is one of the fastest ways to break a deal — and one of the easiest to spot in due diligence.

Customer Concentration

Export the customer list and sort by revenue contribution. If any single customer accounts for more than 15–20% of total revenue, ask:

• Is there a contract in place? How long is the term? Is it assignable?
• What happens if that customer leaves post-close? Model the worst case: subtract that customer’s revenue entirely and recalculate SDE. Does the deal still pencil?
• Is the relationship tied to the seller personally? If the customer buys from “Bob” and Bob is leaving, expect attrition.

Losing your largest customer after close doesn’t just reduce revenue — it changes the business’s cost structure. Fixed costs (rent, insurance, key employees) stay the same while contribution margin evaporates. A business with 30% customer concentration isn’t automatically a bad deal, but it should be priced and structured differently from one with a diversified base.

Supplier Concentration

The same logic applies in reverse. If the business sources 80% of its inventory or raw materials from one supplier, a price increase, supply disruption, or contract non-renewal can crater margins. Ask for supplier agreements, payment terms, and the history of price changes over the last three years. If the supplier relationship is personal to the seller, get an introduction and confirm willingness to continue post-close.

Recurring vs. One-Time Revenue

Pull the revenue into two buckets: recurring (contracts, subscriptions, retainer agreements, repeat purchase patterns) and one-time (project-based, transactional, walk-in). The higher the recurring percentage, the more predictable your post-close cashflow — and the higher the multiple the business commands. Sellers know this and sometimes classify borderline revenue as recurring. Test every line item.

Working Capital: The Peg Nobody Explains Until It Hurts

At close, the seller owns the cash in the business’s bank account and is responsible for the bills incurred before the closing date. But “close” is an instant in time. In practice, the business has inventory on the shelves, accounts receivable you’ll collect, and accounts payable you’ll pay — all of which straddle the closing date.

A working capital peg is a dollar amount of net working capital (current assets minus current liabilities) that must be left in the business at close. It ensures you don’t inherit a hollowed-out shell where the seller collected all the AR and left you with a stack of unpaid vendor invoices.

The peg is typically set at the historical average of net working capital over the trailing twelve months. At close, you calculate actual working capital. If it’s above the peg, the seller gets a true-up payment. If it’s below, the purchase price adjusts downward.

For small deals under $2M, the working capital mechanism is often simplified to a flat dollar amount written into the asset purchase agreement: “$25,000 of working capital must be present at close” or similar. But the principle is the same — you are buying a going concern, not an empty bank account.

“Trust but verify. Every number the seller gives you is a negotiation position, not a fact. Your job in due diligence is to turn positions into numbers you can take to a lender, a partner, or your own bank account.” — HUGE HOLDINGS

DIY vs. Hiring a QoE Provider

What You Can Do Yourself

For deals under $100k–$150k, the math on a professional QoE doesn’t always pencil. The report costs $5k–$10k and the deal is small enough that your own spreadsheet work, plus a CPA review of the tax returns, may be sufficient. What you can handle:

• Bank-to-books reconciliation in a spreadsheet (2–3 hours of work)
• AR/AP aging review from QuickBooks or Xero exports
• Customer and supplier concentration analysis from a revenue export
• Basic add-back legitimacy review using the framework above
• Tax return line-by-line comparison across three years, looking for anomalies
• A CPA review of the business tax returns (typically $500–$1,500, much less than a full QoE)

When to Hire a Firm

For deals above $200k, a professional QoE report from a boutique firm is the industry standard. It costs $3,000–$15,000 depending on the complexity of the business and the depth of review, and typically takes two to four weeks. You commission it after the LOI is signed but before the definitive purchase agreement — it’s part of the confirmatory due diligence period.

A good QoE provider will:

• Reconstruct the seller’s SDE/EBITDA from raw financials and flag every adjustment
• Test revenue recognition against bank deposits and contractual terms
• Identify off-balance-sheet liabilities (pending lawsuits, unfiled payroll taxes, environmental obligations)
• Check for related-party transactions, undisclosed debt, and asset encumbrances
• Produce a report that a lender or partner can rely on

Timing Within the LOI → Close Window

A typical small business acquisition timeline:

• Week 1–2 post-LOI: Engage QoE provider, request document access (bank statements, tax returns, AR/AP aging, customer list, supplier contracts, lease, payroll records)
• Week 2–4: Provider reviews documents, follows up with questions, produces draft report
• Week 3–6: Buyer reviews findings, negotiates price/terms adjustments based on QoE results
• Week 4–8: Legal documentation, working capital peg negotiation, close

Delays in DD are normal. Sellers who push for a 14-day close on a deal over $200k are usually hiding something. Set expectations in the LOI for a 45–60 day DD window and don’t let anyone rush you.

The Due Diligence Checklist

Below is a practical checklist organized by category. Run every item before you sign the definitive purchase agreement. Skip nothing.

Financial Due Diligence

• Three full years of business tax returns (federal and state)
• Three years of P&L and balance sheet (monthly detail preferred)
• Trailing-twelve-month P&L updated to the most recent month
• Three years of business bank statements (all accounts)
• Bank-to-books deposit reconciliation for the last 12 months
• Accounts receivable aging report (identify >90-day balances)
• Accounts payable aging report (identify overdue vendor balances)
• Debt schedule — all outstanding loans, lines of credit, and leases, with terms and payoff amounts
• Payroll register — employees, contractors, compensation, start dates
• Three years of merchant processor statements (Square, Stripe, Clover, etc.)
• Fixed asset register with purchase dates and estimated remaining useful life
• Inventory detail (cost basis, turnover rate, obsolescence reserve)

Legal & Compliance

• Articles of incorporation / LLC operating agreement
• Business licenses and permits — are they current and transferable?
• UCC lien search (state and county) — are there undisclosed liens on assets?
• Pending or threatened litigation, past settlements, and regulatory actions
• Employment agreements, non-competes, and contractor agreements
• Intellectual property assignments (trademarks, domains, proprietary processes)
• Environmental compliance (especially for businesses handling chemicals, fuel, or waste)
• Franchise disclosure document and franchise agreement (if applicable)

Operational Due Diligence

• Lease agreement — remaining term, assignability, renewal options, personal guarantee status
• Real estate title and deed (if real estate is included in the sale)
• Supplier and vendor contracts — are they assignable? At what terms?
• Customer contracts — identify any with change-of-control provisions
• Key employee retention risk — who is at risk of leaving, and what’s the plan?
• Equipment condition and maintenance records
• Insurance policies — coverage scope, premiums, claim history
• IT systems, software licenses, and data access — who owns the domain? Who controls the admin accounts?

Customer & Market Due Diligence

• Revenue concentration by customer (flag >15%)
• Supplier concentration (flag >25% from any single vendor)
• Recurring vs. one-time revenue split
• Customer churn rate over trailing 12 months
• Online presence audit — Google reviews, Yelp, social media, BBB complaints
• Competitor landscape — who opened or closed in the last 24 months?
• Industry tailwinds and headwinds — is the sector growing, flat, or declining?

How Due Diligence Connects to Your Broader Acquisition Plan

Due diligence is the bridge between sourcing and closing. The skills that make you good at DD — verifying numbers, challenging assumptions, reading financials — are the same skills that make you good at valuing a business before you ever sign an LOI. If you skipped the valuation article, go back and read it. The two processes feed each other.

Off-market deals — the kind covered in finding off-market deals — typically come with thinner documentation and more seller optimism than brokered listings. Your DD has to be sharper, not looser, on those deals. The seller may not have a broker assembling a polished package, but the underlying financial reality doesn’t change.

And if you’re pursuing a no money down acquisition — whether through seller financing, a sale-leaseback, or the Bathwater Method — due diligence becomes even more critical. When you’re not putting cash at close, your downside protection has to come from somewhere. Knowing exactly what you’re buying, at exactly what real earnings, is that protection.

This guide is educational and is not financial, tax, legal, or investment advice. Programs, lender policies, and tax rules change. Consult a licensed attorney, CPA, and lender before acting.