Quality of Earnings Goes Mainstream

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What the SBA’s New Requirement Means for Lenders, Buyers and Sellers

The term quality of earnings (QoE) has belonged to the world of private equity and middle market M&A, where enterprise values typically range from $10 million to $1 billion, for decades. This is about to change. Beginning October 1, 2026, the U.S. Small Business Administration’s (SBA’s) new Standard Operating Procedure (SOP) 50 10 8.1 introduces a QoE requirement for certain SBA transactions involving a business purchase price of $3 million or more.

Key Changes Under the New SBA Quality of Earnings Requirements

The new requirements introduce several important considerations for lenders, buyers and sellers as they prepare for implementation.

Mandatory QoE Thresholds and Independence Requirements

• A QoE will be required for qualifying initial acquisitions and business expansions with purchase prices of at least $3.0 million, where change of control occurs. The purchase price is measured before buyer equity, seller debt or other financing and owner-occupied commercial real estate assets are excluded.
  • For example, if the purchase price for a business and real estate totaled $4 million, comprised of $2.5 million for the business and $1.5 million for the real estate, a QoE would not be required under the SBA’s new requirements.
    
    
• Owner buyouts and employee stock ownership plans (ESOP)/cooperative transactions are exempt from the QoE requirement.
  
  
• The QoE must be prepared for the benefit of a lender by an independent, experienced financial professional.

Minimum QoE Procedures and Analytical Requirements

• Reconcile financial statements, tax returns and IRS transcripts to normalized, recurring, arm’s-length earnings.
  
  
• Include a cash proof reconciling bank receipts and disbursements to the income statement and tax returns for the trailing twelve months and prior two fiscal years.
  
  
• Support all adjustments, including non-recurring items, owner compensation, related-party activity, deferred maintenance and cash-to-accrual differences.
  
  
• Evaluate revenue sustainability, customer concentration, contract continuity and post-close margin durability; analyze three fiscal year-ends and current and comparable prior-year interim results.

Underwriting Reliance, Documentation and Debt Sizing

• Lenders must validate seller information against IRS transcripts, use QoE-derived earnings in debt service coverage (DSC) and retain the report in the credit file.
  
  
• Minimum DSC is 1.25x for acquisitions and 1.15x for expansions, representing an increase in the acquisition threshold from the prior general 1.15x minimum, while the expansion threshold remains unchanged.
  
  
• If a QoE-based DSC does not support the valuation or capital structure, debt must be reduced or additional equity contributed.

Opportunities and Challenges

The underlying purpose of the mandatory QoE appears to be the reduction of underwriting risk on debt-backed small business acquisitions, where a modest overstatement of EBITDA, a customer retention issue or an unsupported adjustment can quickly impair debt service capabilities. At the same time, the new standard offers buyers and sellers in the lower middle market an opportunity to bring greater discipline, transparency and credibility to the transaction process.

The following considerations may present meaningful implementation challenges under the new standard for lenders, buyers and sellers:

Lenders

• Establishing policies and procedures to oversee QoE engagements ahead of the approaching implementation deadline.
  
  
• Selecting and onboarding qualified QoE advisors that satisfy applicable independence and experience requirements.
  
  
• Defining the required scope, materiality thresholds and deliverable format for each engagement.
  
  
• Using the QoE to support underwriting through an independent assessment of normalized earnings, cash flow and debt-service capacity.

Buyers/Borrowers

• Assessing the quality, completeness and reliability of the target’s financial information early in the process.
  
  
• Identifying accounting gaps, data limitations and potential normalization items before they delay diligence or affect valuation.
  
  
• Using the QoE to evaluate underlying performance drivers rather than relying solely on seller-prepared financial statements and add-back schedules.
  
  
• Obtaining a clearer basis for assessing sustainable earnings and investment returns.

Sellers

• Preparing for scrutiny from the QoE provider in addition to the buyer’s and lender’s existing diligence procedures.
  
  
• Addressing common small-business limitations, including limited financial infrastructure, cash- or tax-basis accounting and the absence of dedicated accounting personnel.
  
  
• Evaluating complex accounting areas such as percentage-of-completion, work-in-process and contract accounting, where applicable.
  
  
• Improving financial records and support for add-backs early to mitigate diligence delays and challenges to reported earnings.

It is in these circumstances that experienced transaction advisory support can make a difference for lenders, buyers and sellers alike. For lenders, that support can convert imperfect financial information into a focused, defensible assessment of sustainable earnings and debt service capacity. For buyers/borrowers, it can help identify financial risks, validate the investment thesis and establish an appropriate purchase price and capital structure. For sellers, it can help organize financial information, explain historical results and proposed adjustments and reduce the risk of closing delays.

We Can Help

PKF O’ Connor Davies Transaction Advisory Services team has extensive experience working with lower-middle-market businesses that have limited accounting infrastructure, applying a pragmatic, risk-based approach to scope diligence, assess materiality, complete cash proof procedures and evaluate normalization adjustments. By focusing on the items most relevant to the lender’s credit decision, we help streamline information requests, reduce avoidable execution delays and deliver clear conclusions that support timely financing decisions.

Contact Us

For questions or to learn more about how we can support your transaction, contact your PKF O’Connor Davies client service team or:

Shilpa Bhandarkar
Director, Transaction Advisory Services
sbhandarkar@pkfod.com | 908.882.9800

Daniel Pannone
Managing Director, Transaction Advisory Services
dpannone@pkfod.com | 908.956.0455