Pre-LOI diligence turns early interest into a better-informed decision. The task is to test the business story with relevant records before developing a more detailed proposal, while recognizing that access and transaction sequences differ. It is not a promise that every important question can be settled before a letter of intent.
Start with the questions raised by the initial screen and first conversation. If the attraction is repeat business, investigate repeat purchasing. If the owner appears essential, map the work that would need to continue. Financial records help connect those operating questions to the company's reported results.
This article accompanies Module 3: From interest to evidence. Its fictional Cedar Workshop example begins after an indication of interest, or IOI, when the seller has invited the buyer to review further information. That invitation, not the IOI alone, establishes the next permitted step.
Request three years, then ask what changed
Through the agreed confidential process, a practical starting request is the last three completed years of financial statements and business tax returns, plus current-year results against the equivalent prior-year period. Ask for monthly detail where available. Three years is a starting point for investigation, not a universal legal requirement or a complete diligence scope.
The purpose is comparison. A single strong year can conceal a temporary order, an unusual expense, a postponed investment, or a change in the way records were prepared. Multiple periods make it possible to identify questions about direction and consistency. They do not, by themselves, explain the cause of a change.
Be precise about dates. Six months of revenue should be compared with the same six months in the prior year before drawing conclusions about growth. Doubling a half-year result assumes the second half behaves like the first. In a seasonal business, that assumption needs evidence. Ask the accountant to explain changes in accounting treatment before treating differently prepared periods as comparable.
Understand what each record contributes
A profit-and-loss statement, or P&L, presents sales, expenses, and profit or loss over a period. A balance sheet presents assets, liabilities, and equity at a point in time. A cash-flow statement, where available, explains cash movements. These are complementary views, not substitutes. The SEC's guide to financial statements provides a useful introduction to the differences.
| Record | Initial question | What it does not establish alone |
|---|---|---|
| Three annual P&Ls | How have sales, costs, and profit changed? | Whether the latest result will continue |
| Monthly results and current-year comparison | Are changes seasonal or concentrated in particular months? | The reason for the change |
| Balance sheets | What does the business own and owe at each date? | Whether every recorded asset is usable or collectible |
| Cash-flow statements, where available | How did cash move during the period? | The full future funding requirement |
| Business tax returns | What was reported for tax purposes? | An audit or automatic agreement with book accounts |
Business tax returns offer another record for comparison. Book and tax figures can differ for legitimate accounting and tax reasons. Ask the accountant to reconcile material differences rather than treating either agreement or disagreement as conclusive. A filed return is not an audit of the company's financial statements.
The Illinois SBDC business buying guide includes financial statements and tax returns among the records relevant to evaluating an existing business. The appropriate request depends on the company's history and the professional review being undertaken.
Follow a change back to the business
Suppose Cedar's sales increased but profit declined. That observation is a question, not an explanation. Did material costs rise? Did wages increase? Did the company accept lower-margin work? Did the monthly mix change? Ask for the relevant detail and management's explanation, then have the supporting records reviewed.
The buyer should be able to connect the financial question to an operating one. If margins changed because delivery required more subcontractors, the next question concerns the capacity and cost of delivering future work. If a customer paid later, the earnings story and the timing of available cash need separate attention.
Do not turn an early spreadsheet into a forecast by leaving every uncertainty blank. A missing explanation should remain visible in the decision note. It may justify another request, a more cautious assumption, specialist review, or a pause in the process. Its significance depends on what the acquisition thesis needs to be true.
Test an add-back before relying on adjusted earnings
An add-back is a proposed adjustment that excludes an expense from a stated earnings measure. The expense occurred; the question is whether excluding it helps describe the earnings being evaluated. Calling a cost “one-time” does not establish that the business will no longer need the underlying work.
In Cedar's example, the seller proposes excluding a consulting expense. Request invoices and an explanation of the services. A completed project and recurring support may have appeared under the same expense heading. The accountant needs to assess the support and the treatment, rather than relying on the label chosen for the proposal.
At this stage, keep an unsupported adjustment unresolved. Module 4 later develops the example into a documented earnings-review finding. Do not import that later conclusion into the earlier record as though it was already known. The learning sequence matters because a buyer's confidence should change when evidence changes, not merely when a process milestone arrives.
Review customers and owner responsibilities alongside the accounts
Cedar's fictional customer summary shows that its largest customer generated 30% of sales last year. Customer concentration means a substantial share of revenue comes from relatively few customers. Historical concentration is a starting observation. It does not establish the likelihood of losing the customer or guarantee that the relationship will continue.
Ask how long the relationship has lasted, how work is ordered, and what available agreements say about renewal or cancellation. Keep requests and any customer contact within the agreed process. Customer records, commercial analysis, and legal review may each answer a different part of the same question.
Then map the owner's responsibilities. Cedar's owner handles important customers, prepares quotes, and oversees production. If the buyer needs another person to do that work, the proposed role, timing, and cost should be explicit. A management plan that assumes unpaid or unavailable support is not made workable by an attractive historical profit figure.
Financial, customer, operating, and legal questions connect, but each needs the right evidence and reviewer.
Separate acquired assets from permission to operate
Cedar's proposed acquisition includes machinery and tools, but not the building. Ownership of equipment and the right to occupy premises are different matters. The buyer needs to understand what arrangement is proposed and have counsel review relevant documents and permissions.
Do not mark the issue resolved because a lease file appears in the data room. Document receipt does not establish that the buyer can use the premises under the proposed transaction. Keep the question attached to its consequence: what would happen to production if the intended premises arrangement were unavailable?
This is why preliminary diligence should not be only a financial exercise. A missing operating right can remain decisive even when the earnings appear attractive. The findings should be considered together, without assuming every problem can be expressed as a simple reduction in price.
Move from evidence to an informed proposal
For each material question, record the claim, evidence reviewed, remaining uncertainty, and effect on the next decision. The buyer can advance, revise assumptions, pause for an answer, or walk away. Collecting more files is useful only when it improves the understanding needed for that decision.
If the evidence supports continuing, a letter of intent can set out more developed proposed terms. Main commercial terms in an IOI or LOI are commonly intended to be non-binding, while provisions such as confidentiality or exclusivity may bind. Without exclusivity or another restriction, a seller can generally keep considering other offers. Actual wording and applicable law control; counsel should review the document before signature. The ABA's preliminary-agreement discussion explains the risk of relying on a general label.
The next stage is deeper testing, not automatic confirmation. Watch Module 3, then read how post-LOI diligence turns findings into decisions for the connection to Module 4.
General education only. The records and examples are not a complete diligence checklist. Legal, tax, accounting, financing, and valuation conclusions require qualified advisers and the actual transaction facts.