The Anatomy of QoE Adjustments (2/5)

The first time you see a full QoE analysis, it can look overwhelming. Dozens of line items, some adding back to EBITDA, others deducting from it. Reference numbers pointing to footnotes. Categories with names like "normalization" and "run-rate" that seem to blur together.

But underneath the complexity, there is a system. Every adjustment follows a logic. And once you learn to see that logic, you can read any P&L the way an experienced advisor does.

This article walks through how professionals actually identify, categorize, and document QoE adjustments. Not the theory, but the method.

Starting point: management's adjusted EBITDA

In most transactions, the seller or their advisor will present an "adjusted EBITDA" figure as part of the information memorandum or vendor due diligence report. This is the starting point, not the ending point.

Management's adjustments typically fall into two buckets: items they have already excluded from reported EBITDA (like restructuring costs they flagged as exceptional), and items they propose adding back (like transaction fees or one-time bonuses).

Here is the first thing to understand: management has an incentive to present the highest defensible adjusted EBITDA. Not because they are acting in bad faith, but because higher EBITDA means higher valuation. The TS advisor's job is to pressure-test every adjustment.

In practice, I usually start by asking three questions about each management adjustment:

• Is this genuinely non-recurring, or does something similar happen most years?

• Is the amount accurate and supported by documentation?

• Has anything been missed that should also be adjusted?

Some management adjustments will hold up. Others will not. And often, the TS advisor will identify additional adjustments that management did not surface, either because they reduce EBITDA or because management overlooked them.

The four adjustment categories

Every QoE adjustment fits into one of four categories. Understanding this framework helps you see where each item belongs and what questions to ask.

1. Non-recurring items

These are costs or income that occurred in the historical period but are not expected to repeat. The classic examples include transaction costs, restructuring charges, litigation settlements, and one-time bonuses.

The key test is: would we expect this item in a normalized year of operations?

Where this gets tricky is distinguishing between genuinely non-recurring items and items that recur but vary in amount. A company might have litigation costs every year, just not the same litigation. If the pattern shows legal settlements of €200k to €500k annually, the right approach might be to normalize to an average rather than add back the entire amount.

I have seen sellers try to classify ordinary business fluctuations as exceptional. A spike in bad debt expense, a higher-than-usual bonus pool, an expensive trade show. These feel non-recurring to management because they were painful. But from a buyer's perspective, they may represent normal volatility.

2. Non-operating items

Some items flow through the P&L above EBITDA but do not relate to core operations. These need to be reclassified rather than added back.

Common examples include foreign exchange gains or losses that management included in operating income, rental income from property that is not core to the business, investment income, or non-refundable government grants that are not tied to ongoing operations.

The distinction matters because reclassification affects where an item sits in the accounts, while add-backs affect whether the item is included at all. If management classified €300k of FX gains above EBITDA, that should be reclassified below the line, not added to adjusted EBITDA as if it were a recurring benefit.

3. Run-rate adjustments

Run-rate adjustments capture the full-year impact of events that occurred partway through the historical period. They answer the question: what would EBITDA have been if conditions at year-end had existed for the full year?

The most common examples are: a senior hire in September whose full salary impact is not yet in the numbers; a price increase that took effect in Q3; a contract that terminated mid-year and whose contribution should be removed; a new facility that opened in Q2 with only partial-year costs.

These adjustments are necessary because buyers value the business on its current run-rate, not its historical average. If a new CFO was hired in October at €250k annual salary, but only €62.5k hit the P&L, the run-rate adjustment is €187.5k negative to EBITDA.

Run-rate adjustments are often the most contested. They require judgment about what "current state" means and whether changes are permanent. A buyer will scrutinize whether the new hire is actually in place, whether the price increase has stuck, whether the terminated contract might be replaced.

4. Normalization adjustments

Normalization adjustments address situations where the historical numbers are accurate but misleading because they reflect unsustainable arrangements.

The classic example is owner compensation in founder-led businesses. If the founder paid himself €80k when market rate for a replacement CEO is €250k, EBITDA is overstated by €170k. The business cannot operate at that cost level without the founder.

Other examples include related-party transactions at off-market terms (rent paid to a family member at below market rate), deferred maintenance or capital expenditure that boosted short-term margins, and temporarily favorable supplier contracts that are expiring.

These adjustments almost always reduce EBITDA. They represent costs the buyer will actually incur that the seller avoided. In my experience, normalization adjustments are where the biggest surprises hide, because they require understanding how the business has actually been run.

Reading a P&L forensically

The accounts tell you what happened. Forensic analysis tells you what it means. Here is how I approach a P&L when looking for adjustments.

Step 1: Start with the trend

Before looking at individual line items, I look at overall EBITDA margin over three years. Is it stable, improving, or declining? If there is a significant swing in any year, that is where adjustments often hide.

A company showing steady 15% margins for two years that jumps to 22% in the year of sale deserves scrutiny. Something changed. Maybe it is genuine improvement. Maybe it is aggressive accounting or deferred costs.

Step 2: Compare actuals to budget

Ask for the budget for each historical year and compare it to actuals. Where did management over-perform expectations? Where did they under-perform? The gaps often reveal items worth investigating.

If management budgeted €2 million for marketing and spent €1.2 million, the question is whether they under-invested or found efficiencies. If they budgeted €500k for maintenance and spent €200k, the question is whether they deferred necessary work.

Step 3: Examine the outliers

Pull out any P&L line that moved significantly year-over-year (I typically look for swings greater than 20% or €100k, whichever is more material). For each outlier, ask management to explain the driver.

Most explanations will be ordinary: volume changes, price increases, new hires. But some will reveal adjustable items: a large project that closed, a one-time expense, an unusual accrual or reversal.

Step 4: Challenge the labels

Do not accept line item descriptions at face value. A line called "consulting fees" might include one-time transaction advisory costs. A line called "other operating income" might include non-recurring grants or litigation settlements.

Ask for the detail behind any aggregated line. Ask for the supporting invoices behind any large item. The more generic the label, the more likely something is buried inside it.

Step 5: Trace provision movements

Provisions are where adjustments often hide. Every year, companies accrue provisions (charges to EBITDA) and release provisions (credits to EBITDA). The net movement flows through the P&L.

If a company released €800k of unused provisions in the reference year, that boosted EBITDA by €800k. If those provisions related to risks that no longer exist, the release is legitimate. If they were over-accrued in prior years and released to inflate current-year earnings, that is an adjustment.

I always ask for a roll-forward of every material provision: opening balance, additions, utilization, releases, closing balance. The pattern tells you whether provisioning is conservative, aggressive, or volatile.

Red flags that signal hidden adjustments

Over time, you develop pattern recognition. Certain signals reliably indicate that adjustments exist. Here are the ones I watch for:

Margin improvement in the sale year. A sudden jump in profitability right before exit is a classic warning sign. It may be real operational improvement, or it may be deferred costs, accelerated revenue, or reduced discretionary spend.

Large "other income" or "other expense" lines. These catch-all categories are where unusual items hide. Always request the breakdown.

Provision reversals without clear explanation. If a company released €1 million of provisions and cannot clearly explain why the underlying risk disappeared, the release may be artificial.

Related-party transactions. Any transaction with shareholders, family members, or affiliated entities should be scrutinized for market-rate terms. Off-market arrangements create normalization adjustments.

Unusually low spend in key categories. If a company spends significantly less on IT, maintenance, or marketing than comparable businesses, ask whether they are efficient or under-investing.

Revenue recognition policies that permit flexibility. Some businesses have latitude in when they recognize revenue. If management is under pressure to hit targets, they may pull forward revenue from future periods.

Management bonuses tied to EBITDA. If bonuses are linked to the same EBITDA that drives the sale price, management has a double incentive to present favorable numbers.

The distinction between VDD and buyer-side analysis

Vendor due diligence (VDD) is commissioned by the seller. Acquisition due diligence (ADD) is commissioned by the buyer. The distinction matters because their perspectives differ.

VDD reports identify adjustments, but they are presented in a context that supports the seller's narrative. A VDD might acknowledge that a one-time cost should be added back, but frame it generously. It might omit items that are ambiguous but unfavorable.

Buyer-side advisors approach the same numbers with a different lens. Their job is to challenge the VDD, identify items that were missed or understated, and present an independent view of maintainable EBITDA.

In practice, you often see three levels of EBITDA in a deal:

• Reported EBITDA per management accounts

• Adjusted EBITDA per VDD (seller's view)

• Adjusted EBITDA per ADD (buyer's view)

The gap between VDD and ADD is where negotiations happen. If the VDD shows adjusted EBITDA of €15 million and the ADD concludes €13.5 million, that €1.5 million gap becomes a valuation discussion.

Materiality and supporting evidence

Not every item deserves the same attention. Materiality thresholds help focus the analysis on what matters.

A common rule of thumb is 1% of EBITDA or €50k (whichever is lower) as the threshold for individual adjustment consideration. Items below this threshold are typically aggregated or ignored unless they represent a pattern.

But materiality is also about impact. A €100k adjustment might be immaterial in absolute terms but highly material if it recurs every year and the business sells at 10x EBITDA. That €100k becomes €1 million of enterprise value.

Every adjustment should be supported by evidence. The stronger the documentation, the more likely the adjustment will survive buyer scrutiny.

Strong evidence includes: invoices, contracts, board minutes approving one-time payments, employment agreements showing compensation terms, third-party valuations for related-party transactions.

Weak evidence includes: management assertions without supporting documents, spreadsheets prepared for the deal process, estimates based on judgment rather than data.

When I document adjustments, I note both the quantum and the evidence quality. An adjustment with weak support might still be valid, but it will likely be challenged harder in negotiations.

Which adjustments buyers challenge

Not all adjustments receive the same scrutiny. Investment committees and their advisors have learned which categories deserve extra attention.

Add-backs that recur. If a company adds back restructuring costs every year, buyers question whether restructuring is actually non-recurring. "Serial restructurers" get little credit for these adjustments.

Run-rate benefits without run-rate costs. If management claims €500k of run-rate savings from a new contract but does not mention €200k of run-rate costs from new hires, the analysis is one-sided.

Normalization adjustments that favor the seller. If the only normalization is adding back below-market rent, but no one mentions the founder taking above-market salary, the picture is incomplete.

Adjustments based on projections. Some adjustments rely on future events: a contract expected to be won, savings expected from a project not yet completed. Buyers heavily discount these until they materialize.

Large individual adjustments. Any single adjustment greater than 10% of EBITDA will be examined closely. The larger the item, the more documentation required.

The pattern I see in investment committees is this: they credit clean, well-documented adjustments quickly. They challenge aggressive or poorly supported adjustments hard. And they discount anything that feels like an attempt to inflate the number rather than clarify it.

Worked example: a PE-backed software company

To make this concrete, consider a PE-backed software company preparing for exit. Management presents adjusted EBITDA of €11.2 million for the reference year, compared to reported EBITDA of €8.9 million.

Here is how the adjustments break down:

Management proposed: €2.3 million of add-backs (items 1-5)

TS identified: €750k of additional deductions (items 6-10)

TS adjustment to item 4: Reduced litigation add-back by €150k (similar claims occur periodically)

TS adjustment to item 5: Reduced R&D credit to €180k (normalized to sustainable claim level)

Net result: Adjusted EBITDA of €10.4 million, versus management's €11.2 million. The €800k gap represents roughly €6-8 million of enterprise value at typical software multiples.

How documentation quality affects negotiation

The quality of your adjustment documentation directly affects your negotiating position. Vague adjustments invite challenge. Precise adjustments close discussions.

Consider two ways of presenting the same adjustment:

Weak: "We add back €680k for restructuring costs which management considers non-recurring."

Strong: "We add back €680k for restructuring costs comprising: €420k severance for 8 employees terminated in the March reorganization (supported by separation agreements in Appendix C), €180k of consulting fees to McKinsey for the operational review (invoice dated April 15), and €80k of lease termination costs for the closed Munich office (termination agreement in Appendix D). No restructuring charges were incurred in FY-1 or FY-2."

The second version answers every question a buyer would ask. It demonstrates that the advisor did the work. It leaves no room for debate about what the number includes.

In negotiation, well-documented adjustments get accepted. Poorly documented adjustments become chips on the table.

Connecting adjustments to deal outcomes

QoE adjustments do not exist in isolation. They flow directly into deal mechanics.

Valuation. Adjusted EBITDA multiplied by the agreed multiple determines enterprise value. Every €100k of EBITDA adjustment translates into €600k to €1.2 million of value at typical mid-market multiples.

Working capital. Some QoE findings affect working capital rather than EBITDA. An accrual that should have been recognized, a receivable that should have been reserved. These flow into the working capital target and completion adjustment.

Net debt. Certain items identified in QoE may be reclassified as debt-like items: deferred revenue that represents an obligation, provisions that will require cash outflow, earn-outs payable to previous owners.

SPA protections. Adjustments that are contested or uncertain often become warranty or indemnity items. If the buyer is not confident an adjustment will hold, they may accept the seller's number but require protection if it proves wrong.

Post-close disputes. QoE disagreements that are not resolved before signing can resurface as completion account disputes. Clear documentation and agreed positions reduce this risk.

Closing thoughts

Identifying QoE adjustments is a skill that improves with practice. The more P&Ls you review, the faster you spot patterns. The more adjustments you document, the better you understand what holds up and what does not.

If you are new to this work, start by understanding the four categories. Then practice reading P&Ls forensically, looking for the signals that indicate adjustments exist. Build your documentation discipline early, because the habits you form now will determine your credibility in negotiations later.

The goal is not to maximize or minimize adjustments. The goal is accuracy. Buyers and sellers both benefit when the adjusted EBITDA reflects economic reality. That is the foundation for a deal that works for everyone.

This is Part 2 of a 5-part series on Quality of Earnings. Part 3 will cover revenue quality assessment. Upcoming articles will cover cost structure analysis and how QoE findings shape deal outcomes.