How a Sell-side Quality of Earnings Can Help Close a Business Sale

A signed letter of intent isn’t a closed deal. Industry data shows roughly one in three signed LOIs never reaches a closing, and the leading cause isn't financing, market conditions, or buyer remorse. It's what gets discovered during due diligence.

Numbers tell a clear story: Quality of earnings (QoE), EBITDA discrepancies, and other diligence findings together account for nearly half of all failed transactions. Combined, these findings represent the single largest category of deal failure — well ahead of financing issues, seller cold feet, or business underperformance during the process.

Explore today's most pressing QoE issues, red flags slowing or killing transactions, accounting and tax changes reshaping due diligence, and practical strategies keeping sellers confident and deals on track.

1. Today's most common QoE issues — and how they affect valuation

A quality of earnings analysis asks a fundamentally different question than an audit. An audit asks, "Are these numbers accurate?" A QoE asks, "Are these earnings sustainable?" That distinction matters enormously in M&A, because deal value is calculated as a multiple of earnings. When the QoE reveals defensible EBITDA is materially lower than what the LOI was priced on, the math changes immediately and often dramatically.

Aggressive or undocumented add-backs

The most frequent QoE issue in middle-market transactions remains aggressive or undocumented EBITDA add-backs. Sellers routinely adjust reported earnings to reflect what they believe is the "true" run-rate of the business — removing owner compensation above market rates, one-time legal fees, non-recurring consulting projects, or COVID-era anomalies. The problem is not the add-backs themselves; it's when they are unsupported, inconsistent, or stretch the definition of "non-recurring" beyond what a buyer's QoE provider will accept.

In owner-operated businesses, adjusted EBITDA can differ from reported EBITDA by 30–50% or more. When a buyer's QoE team can’t independently verify those adjustments, the gap between seller expectations and buyer-validated earnings widens; and that gap is where deals die or get repriced.

Revenue recognition inconsistencies

Revenue is often the first area where red flags appear. Common issues include recognizing revenue before performance obligations are satisfied, booking one-time project revenue as if it were recurring, or shifting revenue between periods to smooth results. For companies on a cash basis or using inconsistent recognition methods, the QoE team normalizes revenue to what GAAP-compliant accrual accounting would show, and the result often looks different from what the seller presented.

Working capital anomalies

Working capital adjustments appear in most private M&A transactions. Seasonal fluctuations, accelerated collections before a sale, deferred payables, or a sudden inventory build can all distort the working capital picture. These anomalies frequently lead to purchase price adjustments surprising unprepared sellers and creating post-closing friction between buyer and seller.

Customer concentration risk

When more than 20–25% of revenue comes from a single customer or a small group of customers, buyers get nervous and rightfully so. Customer concentration creates dependency risk directly affecting the multiple a buyer is willing to pay. A business with diversified revenue across many customers is inherently less risky than one where the loss of a single relationship could materially impair earnings.

Weak cash conversion

High reported earnings paired with weak operating cash flow is a significant red flag. The ratio of cash flow from operations to net income is a quick litmus test: A result consistently above 1.0 is a positive sign. When earnings look strong on paper but cash isn't following, it often signals aggressive accounting, growing receivables that may not collect, or operational inefficiencies eroding real value.

2. Key red flags slowing down or derailing a deal

Not all diligence findings are equal. Some raise concern; others kill deals. Understanding the hierarchy of red flags — and addressing them before a buyer's team arrives — is the difference between a smooth close and a collapsed transaction.

The anatomy of a dead deal

Industry research into failed LOIs consistently identifies the same categories of deal failure:

The critical takeaway: Diligence-driven failures are rising while financing-driven failures are declining. As capital has become more accessible, buyers are redirecting their attention toward scrutiny. The deals that break increasingly break because the buyer found something.

The red flags triggering deeper scrutiny

Messy financial records

Inconsistent or incomplete financial reporting is the most common red flag buyers encounter. When monthly results don’t reconcile, when cash flow statements are unclear, or when the business relies on spreadsheets and manual bookkeeping, confidence erodes immediately. Buyers expect investor-grade reporting: Monthly closes, GAAP-compliant statements, and clear audit trails.

Overstated or one-time revenue presented as recurring

Revenue spikes from unusual events — a one-off government contract, a real estate sale, pandemic-related surges — presented as ongoing performance are quickly identified by sophisticated buyers. Inflated revenue undermines trust and triggers more intense scrutiny of all reported numbers.

Owner dependency

When the business can’t function without the founder — when key relationships, institutional knowledge, and decision-making authority all reside in one person — buyers see risk. Owner dependency is one of the most common non-QoE findings in lower middle-market deals and frequently leads to earnout structures or reduced multiples.

Contract non-assignability

Change-of-control clauses allowing major customers or suppliers to walk upon a sale can fundamentally alter the value proposition. Buyers who discover that key contracts don't transfer have a legitimate reason to re-trade or walk.

Lack of inventory and asset tracking

In manufacturing, construction, and distribution, poor inventory management can be a deal breaker. If buyers can’t verify the existence, accuracy, or value of assets, they assume risk is higher and adjust their offers accordingly.

Compliance gaps

Unresolved litigation, licensing gaps, regulatory exposure, employment classification issues, and environmental liabilities all create risk buyers must price into the deal or avoid altogether.

3. Accounting standards, tax updates, and external factors reshaping due diligence

The due diligence landscape in 2026 is shaped by three converging forces: Evolving accounting standards, sweeping tax legislation, and macroeconomic disruption from tariffs and trade policy. Transaction advisors who understand these forces can better prepare their clients and anticipate the questions buyers will ask.

Recent federal tax legislation: The biggest shift since 2017

Recent federal tax legislation has introduced the most significant changes to business taxation since the 2017 Tax Cuts and Jobs Act. For M&A practitioners, several provisions directly affect how deals are structured, valued, and analyzed:

• 100% bonus depreciation (permanent) — Recent legislation permanently reinstated 100% bonus depreciation for qualified property. This means capital investments in machinery, equipment, and qualifying facilities can be fully deducted in the year placed in service — transforming how buyers model post-acquisition capital expenditure plans and after-tax returns.
• Domestic R&D expensing restored — The prior requirement to capitalize and amortize R&D expenditures over five years has been reversed. Immediate expensing for domestic R&D spend is now restored, and small businesses may be able to retroactively expense certain prior-year R&D costs for a limited time period. For technology and manufacturing targets, this materially changes the adjusted EBITDA and cash flow picture.
• Business interest deduction liberalized — The business interest deduction limitation has returned to a more generous EBITDA-based formula (from the tighter EBIT-based calculation), providing more favorable interest deductibility for leveraged acquisitions.
• Qualified production property expensing — New provisions allow immediate deduction of certain factory and production facility costs — a category previously depreciated over decades. For manufacturing and industrial targets, this can significantly alter the tax-adjusted valuation.

For QoE practitioners, these changes mean historical tax positions may not reflect the go-forward reality. Normalized earnings analyses must account for the new deduction landscape, and deal models should stress-test valuations under both the prior and current tax regimes.

Key accounting standards affecting current reporting

Several recent FASB Accounting Standards Updates (ASUs) are now effective or becoming effective, and each has potential implications for how target company financials are prepared and evaluated in diligence:

• Credit losses on receivables and contract assets — New measurement guidance for credit losses on accounts receivable and contract assets changes how aging schedules and allowances are calculated — directly impacting working capital analysis in QoE reports.
• Accounting acquirer guidance for VIE acquisitions — Updated guidance on identifying the accounting acquirer in business combinations involving variable interest entities affects how roll-up strategies and platform acquisitions are structured and reported.
• Internal-use software cost capitalization — Updated guidance on internal-use software costs changes how technology companies capitalize development spending. QoE teams evaluating SaaS and technology targets should be prepared for restatements as companies adopt new standards.
• Expense disaggregation disclosures — New requirements for disaggregation of income statement expenses increase transparency and the volume of data QoE teams must analyze. The upside: More granular visibility into cost structures and margin drivers.

Tariffs and trade policy: The new diligence workstream

Tariffs and trade policy have moved from a footnote in legal diligence to a central analytical workstream. The rapid escalation of U.S. tariffs — including significant duties on goods from key trading partners — has fundamentally altered cost structures for companies with international supply chains.

For QoE and financial due diligence, tariffs create several new challenges:

• Margin sustainability — Companies with tariff-exposed supply chains face margin compression that may not yet be reflected in historical financials. QoE teams must assess whether current margins are sustainable or artificially inflated by pre-tariff inventory purchased at lower costs.
• Forecast reliability — Traditional valuation models struggle with tariff uncertainty. Buyers are increasingly requiring scenario-based forecasts modeling different tariff outcomes and their cascading effects on EBITDA.
• Supply chain exposure — Buyers now evaluate the full upstream and downstream supply chain: Where are raw materials sourced? What's the fallback if a region is hit with new tariffs? Who absorbs tariff-related cost increases — supplier or buyer?
• Hidden liabilities — Misclassification of goods, unrecorded tariff-related liabilities, and penalties for terminating supply agreements can create hidden exposures eroding post-closing EBITDA.

4. Practical strategies for maintaining seller confidence

Seller confidence is the invisible infrastructure of every successful transaction. When confidence erodes — because diligence takes too long, because unexpected findings surface, because the buyer's tone shifts — sellers make emotional decisions killing deals. Managing seller psychology is as important as managing the numbers.

Start with a sell-side QoE

The most effective strategy for maintaining seller confidence is conducting a sell-side quality of earnings analysis before going to market. A sell-side QoE puts the seller in control: It identifies and cleans up potential red flags in advance, normalizes earnings with supporting documentation, and prepares the data room to withstand buyer scrutiny.

Sellers walking into diligence prepared experience fewer surprises, less distraction for their teams, and stronger footing in negotiations. The growing investment in sell-side diligence services across the industry is a clear signal sophisticated sellers understand the value of preparation.

Set realistic expectations early

Many deals falter because sellers enter the process with inflated expectations based on what the business means to them rather than what the market will pay. A professional valuation, benchmarked against recent comparable transactions, grounds expectations in reality. When a seller understands buyers look at cash flow, risk, scalability, and synergy — not sentiment — they are better prepared for the give-and-take of negotiations.

Manage the timeline proactively

Standard diligence runs 6–8 weeks from LOI to closing. Every week of delay increases the risk of deal fatigue, information leakage, and business underperformance. Proactive timeline management means having the data room organized before the LOI is signed, responding to information requests within 24–48 hours, and keeping the seller informed of progress at every stage.

Own the issues before the buyer finds them

When an issue surfaces during diligence, the worst response is denial or surprise. The best response is to own it, provide context, quantify the impact, and propose solutions. A seller who proactively discloses a known issue — with supporting analysis — builds trust. A seller who appears to have hidden the same issue destroys it.

Keep the business performing

In a meaningful number of failed deals, the business itself declined during the diligence period. This is partly bad luck and partly a management problem. The risk rises when the owner becomes so consumed by the deal process the business drifts. The practical defense: Delegate enough that the deal doesn't pull the owner off the floor, maintain normal sales and marketing activity, and avoid the temptation to coast toward closing.

Communicate consistently

Silence breeds anxiety. Regular status updates — even when there's nothing new to report — keep sellers engaged and confident. A weekly call or email summarizing progress, upcoming milestones, and any outstanding items goes a long way toward maintaining the emotional equilibrium carrying a deal to closing.

5. Actionable insights for business owners

The following recommendations are designed to be implemented immediately, whether you're in the middle of a live deal or preparing for market entry.

Pre-market preparation (12–24 months before sale)

• Commission a sell-side QoE — Engage a QoE provider to conduct a sell-side analysis. Identify normalization adjustments, document add-backs with supporting evidence, and resolve any issues that would give a buyer's team pause.
• Upgrade financial reporting — Move to monthly closes, GAAP-compliant statements, and accrual-based accounting. If the business is on a cash or tax basis, prepare GAAP-adjusted financials for the trailing three years.
• Model the current tax landscape — With recent tax legislation permanently reinstating bonus depreciation and R&D expensing, work with a CPA to model how these provisions affect the seller's after-tax proceeds and the buyer's return profile.
• Assess tariff exposure — For any business with international supply chain exposure, prepare a tariff impact analysis modeling current and potential tariff scenarios and their effect on margins.
• Address concentration and contract risks — If more than 20% of revenue comes from a single customer, begin diversification efforts. If key contracts have change-of-control provisions, negotiate amendments before going to market.
• Build management depth — Reduce owner dependency by building a management team that can operate independently, documenting key processes, and transitioning critical relationships.

During the deal process

• Organize the data room early — Prepare a comprehensive data room before the LOI is signed. Include three to five years of financial statements, tax returns, customer lists, contracts, organizational charts, and supporting schedules for all proposed EBITDA adjustments.
• Create a diligence timeline — Map every management meeting, site visit, data request, and response deadline. Share the timeline with the seller and update it weekly. 
• Maintain seller communication — Schedule weekly check-ins with the seller covering progress, upcoming milestones, and any issues that have surfaced. Frame findings as "things we're working through" rather than "problems."
• Anticipate buyer questions — Don't wait for the buyer's QoE team to ask. Provide supporting documentation for every normalization adjustment in the initial data room submission.
• Monitor business performance — Track KPIs throughout the diligence period so the business doesn't slip. If results soften, address it proactively rather than waiting for the buyer to notice.

Post-LOI recommendations

• Prepare issue response packages — When a diligence finding surfaces, quantify the EBITDA impact and prepare a response memo before the buyer asks. Show you've already thought through the issue.
• Negotiate from data, not emotion — If the buyer's team identifies a working capital anomaly or requests a peg adjustment, have your own working capital analysis ready to present. Don't negotiate from the buyer's model alone.
• Educate yourself on deal mechanics — Understand how purchase price adjustments, escrows, and indemnification provisions work before they appear in the purchase agreement. Surprises at the contract stage erode confidence.

How CLA can help with business transactions

At CLA, our transaction advisory services team brings together integrated financial, tax, operational, and IT due diligence capabilities with deep industry knowledge across health care, manufacturing and distribution, financial services, construction, technology, and more.

We go beyond traditional accounting and financial analysis to scrutinize the key assumptions underlying every deal. Our approach is designed to help you — whether you're a private equity sponsor, a business owner preparing for sale, or lender underwriting a transaction.

CLA’s business transaction advisory capabilities

• Quality of earnings (QoE) analysis — Buy-side and sell-side QoE analyses that identify sustainable earnings, normalize EBITDA, evaluate working capital trends, and flag risks that could impact valuation or deal terms. Our reports are built to help you negotiate smarter, avoid surprises, and move faster with confidence.
• Transaction tax advisory — Comprehensive assessment of federal, state, and local tax exposure, transaction structuring opportunities, and post-deal tax planning to help reduce risk and increase after-tax value, including full modeling of current tax provisions.
• Working capital analysis — Historical trend analysis, working capital peg development, and projected working capital analysis to help prevent post-closing disputes. 
• Valuation and financial modeling — Valuation financial modeling, fair value measurement for financial reporting, and purchase price allocation support.
• Operational and IT due diligence — Assessment of operational readiness, management depth, systems infrastructure, and integration planning — particularly the critical first 100 days post-close.
• M&A advisory and investment banking — Full-service investment banking and M&A advisory for middle-market transactions, including sell-side representation, buy-side support, and capital raising.
• Owner transition advisory — Holistic transition planning addressing the personal, financial, and strategic dimensions of ownership change.

CLA's transaction advisory professionals aren’t generalists reviewing a checklist. We are deal practitioners who understand how QoE findings translate into purchase price adjustments, how tax structuring creates value, and how proactive preparation protects the deal from LOI to closing and beyond.