Quality Of Earnings Reports For SBA Acquisition Loans

What A Quality Of Earnings Report Is

A business valuation answers one question: what is this business worth? A quality of earnings report answers a different one: are the earnings behind that value real, repeatable and accurate?

A QoE is prepared by an independent, experienced financial professional, usually an accounting firm that specializes in transaction work. It reconciles the business's accountant-prepared financial statements, tax returns, internal books and IRS transcript data, and produces a normalized, adjusted earnings figure that reflects recurring, arm's-length operations.

For a buyer, that is valuable on its own. A QoE often finds the issues that would otherwise show up in your first year of ownership.

When SBA Requires A QoE

SBA requires a QoE, in addition to the business valuation, when both of these are true:

• The deal is an Initial Acquisition (you are buying a business you do not already own) or a Business Expansion (an existing business buying another in the same industry group).
• The Business Purchase Price is $3,000,000 or more.

Owner Buyouts and ESOP purchases are exempt, because the existing owners already know the business. A purchase that includes an owner-occupied Special Purpose Property, such as a hotel or self-storage facility, is also exempt from the QoE, though it still needs a valuation.

How The $3,000,000 Is Measured

Two details decide whether you cross the line:

1. Real estate is removed. The Business Purchase Price excludes owner-occupied commercial real estate. When a building is in the deal, the lender subtracts its appraised value from the contract price.
2. Financing does not reduce it. The threshold is measured before your Down Payment, seller notes or any other financing. A big seller note does not get you under $3,000,000.

Who Orders It And Who It Is For

The QoE must be conducted for the benefit of the lender. It cannot be prepared by or for the seller, so a seller's sell-side QoE does not satisfy the requirement.

Many buyers commission their own QoE before they have a lender, as part of their own diligence. That can still help. A lender may have the buyer's report reviewed by one of the lender's approved vendors to save cost, and it puts both the original report and the review in the file. But a lender may not rely on another party's QoE without that vendor review.

What The QoE Must Include

SBA spells out the contents:

• A Cash Proof: bank statement deposits and disbursements reconciled to the income statement and tax return, for the trailing 12 months and the last two fiscal years
• Every add-back and adjustment to the seller's earnings, documented, including non-recurring items and above or below-market owner pay
• Related-party transactions, such as rent paid to the seller's own real estate company
• Deferred maintenance and differences between cash and accrual accounting
• The quality and sustainability of revenue, including customer concentration and contract continuity
• Whether revenue and margins are likely to hold after the sale

The Cash Proof is the heart of it. It is designed to catch income that was reported but never deposited, and expenses that were paid but never recorded.

How The QoE Changes Your Loan

This is the part buyers most need to understand. The lender must use the QoE's earnings to calculate debt service coverage. If the QoE earnings do not support the valuation and the proposed debt, the loan amount has to come down. You can add more equity, from unlimited or limited sources, to make up the difference.

A QoE can also give you a reason to renegotiate. If the price was based on $820,000 of earnings and the real number is $730,000, you have a documented basis for a lower price or a different structure. See negotiating price and terms.

Cost, Timing And The Down Payment

The QoE is usually paid by you, the buyer. SBA lets the lender pass the cost of financial due diligence reports to the borrower, and three things soften that:

• The QoE can be financed in the SBA loan as a borrower out-of-pocket cost.
• Money you spend on the report counts toward your Down Payment.
• If you already commissioned a QoE, a vendor review may cost less than a new report.

Cost depends on the size and complexity of the business, so ask for a quote as soon as the LOI is signed. On timing, the rules depend on how the lender processes the loan. A lender with delegated SBA authority must have the QoE formally engaged, with an engagement letter in place, when the SBA loan number is issued, and the report must be reviewed before closing. A lender submitting the loan to SBA for approval must include the QoE with the application. Either way, the QoE is often the longest item on the LOI to closing timeline.

How To Prepare For A QoE

1. Get the seller's records early: three years of returns and financials, monthly bank statements, payroll reports and the general ledger.
2. Ask the seller for an add-back schedule with support for each item.
3. Flag related-party arrangements like family on payroll or rent paid to the seller's own company.
4. Expect questions. Quick, complete answers from the seller keep the report on schedule.

The QoE works hand in hand with the lender's valuation. Read SBA business valuation requirements and the due diligence checklist for the rest of the process, or see the SBA business acquisition loan page. If your deal is near the $3,000,000 line, a pre-qualification letter will show how the QoE fits your timeline and structure.