Phased Due Diligence: Ways to Protect Your Deal

Overview of the 4 Phases of Financial Due Diligence

When we think about the four phases of financial due diligence, where are we in the process?

If you have a signed LOI and have started out with due diligence, you are granted 30, 60, or 90 days of exclusivity to analyze the business from a financial, tax, legal, and operational risk standpoint

Financial due diligence is a core component of this process

Why you must start early in the LOI

Once you have a signed LOI, you should kick off financial due diligence within the first 1 to 30 days of your exclusivity period

It is also helpful to start the SBA or private credit underwriting process

The reason why both should start early:

• if there are significant financial information that’s unpacked
• you want to learn that earlier rather than later

If the business is looking a little bit different than what you anticipated, the sooner the better

Phase 1: financial validation and baseline assessment

The first milestone is phase one: financial validation and baseline assessment

The point of this phase is to ensure the data is accurate and validated against source documents

Does the business financials tie back to:

• tax returns
• bank statements
• general ledger

If the high-level information is not tying out, there is no point to start detailed analysis

Once everything is validated, you set the stage for phase two

Phase 2: quality of earnings and value analysis

Phase two is the bulk of the quality of earnings and value analysis

You gather financial records and contracts
Analyze earnings consistency and adjustments
Conduct a value assessment

This includes:

• earnings normalization
• working capital analysis
• revenue quality testing

You also perform deeper analysis:

• proof of cash
• operating expense review
• gross margin analysis

The proof of cash traces revenues and expenses back to bank deposits

It shows how cash moves through the business

Phase 3: financial modeling and stress testing

Phase three is taking the base case of the company and putting together a financial model

Typically a three-year proforma model

Used for SBA loan underwriting and financial planning

You forecast:

• best case scenario
• worst case scenario

For example:

• revenues decline by 20 percent

Can the business still support the bank loan

You also conduct:

• know your customer analysis
• management interviews
• investment thesis validation

You want to answer:

Can this business support the bank loan?
Does it have enough cash flow to pay the monthly payments?

Phase 4: final financial updates before closing

Phase four is the final stretch before closing

You perform a financial update by rolling forward the financials to see how the business is performing in the last 60 days

You want to understand:

• has the business materially changed
• is it steady and consistent

You also complete:

• working capital true up
• opening balance sheet
• final red flags review

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