Why two businesses with the same Seller’s Discretionary Earnings (SDE) can be worth radically different multiples.
Most first-time buyers anchor on one question:
“Is the $800K SDE number real?”
They review add-backs, confirm owner compensation, check discretionary expenses, and—once satisfied—apply a multiple.
But validating SDE is not the same as understanding valuation.
Two businesses can both report accurate $800K SDE, yet one is worth 2.5× while the other commands 4.0×.
The difference isn’t in the add-backs.
It’s in the Quality of Earnings (QoE**)**—the structural factors that determine whether earnings are stable, repeatable, and cash-generative.
This article breaks down what Quality of Earnings actually examines, why it drives multiples, and how buyers can surface valuation-critical issues before they end up renegotiating the LOI.
1. What Quality of Earnings Actually Measures
(And why SDE validation isn’t enough)
Quality of Earnings (QoE) answers a single question:
Are the earnings repeatable?
It evaluates:
Durability – Will key customers, contracts, and margins hold post-close?
Cash conversion – Does the business turn revenue into actual cash, or does it consume capital?
Expense sustainability – Are current earnings propped up by deferred spend?
Margin stability – Are gross margins trending up, stable, or eroding?
Free-cash-flow reality – How much annual capex is required to sustain operations?
Validating SDE = accuracy.
Quality of Earnings = repeatability.
Buyers who don’t make this distinction are negotiating on an incomplete picture.
2. The Five Drivers That Actually Determine a Business’s Multiple
The market does not price businesses on raw SDE.
It prices them on the risk and quality of those earnings.
Below are the five drivers that most materially move valuation.
2.1 Customer Concentration
How revenue dependency moves multiples by 1–2 full turns**
What it measures
How reliant the business is on a small number of customers.
Why it drives valuation
If 40% of revenue sits with one customer, you aren’t buying an $800K SDE business—
you’re buying a single-customer risk profile.
What to examine
Top 5 customers as % of revenue
Top 5 customers as % of gross profit
Contract terms and renewal cycles
3-year retention
Whether relationships sit with the owner
The valuation impact
Business A: $1M SDE, largest customer = 8%
Business B: $1M SDE, largest customer = 45%
Same earnings.
Business A may trade at 3.8×; Business B at 2.2× or with heavy earnouts.
That’s a 1.5×+ multiple swing based purely on concentration.
2.2 Cash Conversion Cycle
Why identical SDE can require $500K more working capital**
What it measures
How quickly revenue becomes cash.
Why it drives valuation
Two businesses with identical SDE can produce radically different cash requirements:
Some generate cash immediately.
Others lock cash in inventory + receivables for 60–90 days.
The formula
Days Sales Outstanding (DSO) + Inventory Days – Days Payables Outstanding (DPO) = Cash Conversion Cycle
The valuation impact
Business A
Paid upfront
No inventory
Pays suppliers in 30 days
→ Cash Conversion Cycle: –30 days
Business B
75-day collection
45 days inventory
30-day payables
→ Cash Conversion Cycle: 90 days
For a $2M revenue business:
Business B may require $400K–$500K in working capital that Business A doesn’t.
You effectively pay a higher “real” purchase price once you factor in the capital the business consumes.
2.3 Expense Timing
Why Trailing Twelve Months (TTM) often overstates true run-rate earnings
What it measures
Whether trailing-twelve-month expenses reflect future operations.
Why it drives valuation
TTM earnings can be inflated if the seller:
Cut marketing temporarily
Deferred maintenance
Slowed hiring or raises
Postponed system upgrades
All of these make SDE look stronger—but not sustainable.
The valuation impact
Example 1: Recurring “one-time” expenses
A business does a $50K IT upgrade every 2–3 years.
Brokers label it “non-recurring.”
But normalized run-rate is: $50K / 3 = ~$17K/year.
Failing to capture this inflates normalized cash flow.
Example 2: Deferred spending
TTM looks great because:
Marketing down 40%
Raises paused
Repairs delayed
These aren’t improvements—they’re timing artifacts.
QoE corrects them.
2.4 Gross Margin Trends
How a 5-point margin erosion turns a 4.0× business into a 2.5× business
What it measures
Margin stability over time.
Why it drives valuation
Stable margins signal pricing power.
Declining margins signal competitive or cost pressures.
What to examine
24–36 months of gross margin trends
Margin by product line
Drivers of erosion: competition, COGS inflation, channel shifts
The valuation impact
Business C:
$600K SDE
Margins stable at 42% for 3 years
→ Trades around 4.0×
Business D:
$600K SDE
Margins eroding 44% → 38% → 35%
→ Trades around 2.5×
Same SDE, different earnings durability.
2.5 Recurring Capital Expenditures (Capex)
The gap between $500K SDE and $429K true free cash flow
What it measures
The annual capital required to keep operations running.
Why it drives valuation
SDE excludes capex.
But buyers must fund it.
The valuation impact
A business showing $500K SDE may require:
$64K/year (vehicles)
$7K/year (equipment replacement)
Recurring capex = ~$71K
True free cash flow:
$500K → $429K
You’re valuing $500K but buying $429K of real cash flow.
This is why QoE focuses on free cash flow, not SDE.
3. The Pre-LOI QoE Checklist
(What to verify before you ever submit an offer)
Most valuation mistakes happen before LOI.
Run this diagnostic first:
Customer Concentration
□ Top 5 customer %
□ Contract status
□ 3-year retention
□ Owner-held relationships
Cash Conversion
□ AR aging report
□ AP aging report
□ Inventory levels
□ Calculate CCC over 12 months
Expense Timing
□ 3-year expense trends
□ Deferred spend
□ Identifiable recurring “one-time” items
Gross Margin
□ 2–3-year margin trend
□ GM by segment/product
□ Drivers of variance
Recurring Capex
□ Capex over 3 years
□ Replacement cycles
□ Deferred replacement risk
If you can’t answer at least 80% of these confidently, your LOI price carries high re-trade risk.
4. How to Adjust Price and Structure When QoE Reveals Issues
Every deal has issues.
Sophisticated buyers respond with frameworks, not emotion.
1. High Customer Concentration (40%+)
Lower the multiple
Add earnouts tied to renewal
Tie closing payments to customer retention milestones
2. Long Cash Conversion Cycle
Reduce the purchase price by the working-capital (WC) requirement
Or shift WC risk to seller via note
3. Declining Margins
Lower the valuation multiple to reflect earnings deterioration
Structure an earnout that activates only upon margin stabilization
Walk away if margin erosion is structural and not recoverable
4. High Recurring Capex
Normalize free cash flow
Revalue the business on adjusted free cash flow, not SDE
5. Understated or Deferred Expenses
Normalize expenses upward
Recalculate cash flow and adjust valuation accordingly
This is how disciplined buyers maintain trust while correcting price.
5. When to DIY vs. Hire QoE
DIY Pre-LOI QoE ($0–$2K)
Best for: Any deal
Outcome: Directional answers to the 5 core drivers
QoE-Lite ($5K–$12K)
Best for: $1M–$3M deals
Outcome: Normalized earnings + red flags
Full QoE ($15K–$40K)
Best for:
$3M+ deals
SBA + conventional debt
Pari passu structures (read the latest Evermark analysis: How Pari Passu Lending Expands the Capital Stack for SMB Buyers)
Institutional investors
Outcome: Lender-ready report
The Bottom Line
Quality of Earnings reveals the real drivers of valuation:
Customer concentration
Cash conversion cycle
Expense timing
Gross margin durability
Recurring capex
These five factors routinely move valuations 1–2 full turns of multiple, far more than any individual add-back.
Most buyers validate the SDE number and stop.
Sophisticated buyers evaluate the quality behind it—and structure their offers accordingly.
If You’re Buying Your First Business or Running Your First Search
Evermark’s weekly brief breaks down the fundamentals of disciplined acquisition strategy:
Quality of Earnings frameworks
Working capital modeling
Customer risk structuring
Pre-LOI diligence checklists
Valuation and structure mechanics
Real case studies from $1–10M SMB deals
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