The Letter of Intent (LOI) is signed. The champagne has been popped. The valuation is set at a healthy 10x multiple on $10M EBITDA. Then, the Quality of Earnings (QoE) team arrives.
Three weeks later, they drop a PDF that erases $18M of enterprise value overnight.
The culprit isn't a lost customer or a product failure. It is Revenue Recognition. Specifically, the gap between how a founder-led company books cash and how a Private Equity buyer calculates compliant revenue under ASC 606. For Operating Partners, this is the most frustrating way to lose a deal or, worse, inherit a lemon.
In the mid-market, financial reporting is often treated as a compliance burden rather than a valuation driver. Founders conflate "bookings" (signed contracts) with "revenue" (delivered value). They recognize multi-year upfront payments immediately to boost EBITDA. When the QoE normalizes this, your growth rate flattens, your margins compress, and the deal typically dies on the table—or retrades at a humiliating discount.
Data from software M&A transactions indicates that over 50% of deals require EBITDA adjustments, with revenue recognition errors being a primary driver. These aren't just accounting fixes; they are valuation events. If you are assessing a target or prepping a portfolio company for exit, you cannot rely on the audited financials alone. You must look at the revenue architecture underneath.
When our teams conduct Revenue Quality Audits, we repeatedly encounter three specific behaviors that inflate reported EBITDA. Understanding these traps is essential for accurately pricing risk.
Many B2B SaaS and service firms charge a substantial upfront "setup" or "onboarding" fee. A founder-led finance team will often book this entire $50,000 fee in the month it is collected, spiking EBITDA.
The Reality: Under ASC 606, unless that setup service provides distinct value separate from the software, it must be deferred and recognized over the estimated life of the customer (often 3-5 years).
The Impact: That $50,000 EBITDA bump becomes ~$1,400 of monthly revenue. If the company is trading at 10x EBITDA, you just lost $500,000 of Enterprise Value from a single contract error. Across a customer base of 200, this error alone can wipe out millions in valuation.
Aggressive sales teams often push for "conditional" contracts to hit quota at quarter-end. These contracts might have opt-out clauses, acceptance criteria, or delayed start dates. In messy financial infrastructure, these are often booked as revenue immediately upon signature.
This creates "Phantom Revenue"—earnings that look real on the P&L but have no underlying cash flow or legal enforceability. When the QoE team reverses these, it doesn't just lower revenue; it signals a lack of financial control that can spook lenders and investment committees alike.
We frequently see hybrid firms (Tech-Enabled Services) attempting to value themselves as pure SaaS. They bury low-margin professional services revenue into their subscription line items to artificially inflate Gross Margins.
The Benchmark: Pure SaaS should have 80%+ gross margins. If a target claims 85% margins but has a large "Customer Success" team doing manual data entry, they are misallocating COGS. A proper restatement often reveals margins are actually 60%, crushing the valuation multiple.
You cannot wait for the buyer's accounting firm to tell you what your EBITDA is. Whether you are buying a company or preparing one for sale, you must execute a defensive revenue audit 6-12 months before a transaction event.
Don't wait for the audit. Move your portfolio companies to compliant revenue recognition now. Yes, it might temporarily lower reported EBITDA, but "clean" numbers command a premium. Buyers pay more for predictability than they do for inflated, risky growth. Use our guide on SaaS Board Reporting to standardize how these metrics are presented to stakeholders.
Force a hard separation between Recurring Revenue (Licenses/Subscriptions), Re-occurring Revenue (Maintenance/Retainers), and Non-Recurring Revenue (Projects/Setup). This clarity prevents the "blending" that triggers red flags during diligence.
Finally, implement a monthly reconciliation between Revenue Recognized and Cash Collected (adjusted for Deferred Revenue changes). If Revenue is consistently growing faster than Cash + Deferred Revenue, you are likely looking at aggressive recognition practices.
Conclusion
Financial engineering cannot fix a broken business model, but broken financial infrastructure can kill a great exit. By treating revenue recognition as a strategic asset rather than a compliance chore, you protect your multiple and ensure that when you say "$10M EBITDA," the market believes you.
