What Financial Due Diligence Should Cover Before You Sign an LOI
A letter of intent feels like progress, and it is. It is also the point where a buyer’s negotiating position starts to weaken. Once exclusivity begins, the seller stops talking to other bidders and the clock runs on your due diligence. Buyers who wait until after signing to study the financials often find problems when they have the least room to renegotiate. Reviewing the right items early lets you set a price and terms that hold up.
Why Financial Due Diligence Belongs Before the LOI
Most LOIs state a price, a deal structure, and an exclusivity period, commonly 45 to 90 days. That price rests on the financials the seller has shared so far, which are usually prepared by management and unaudited. A buyer does not need a full diligence process at this stage. A focused first pass is enough to confirm that the numbers behind the price are sound and to decide which terms need protection in the letter itself.
Early findings shape the language of the LOI. A concern about working capital can become a target level written into the letter. A concern about one large customer can become a condition tied to that relationship. Those changes are far easier to write in before signing than to request afterward.
Quality of Earnings
Quality of earnings answers a simple question: how much of the reported profit will continue after closing? Sellers commonly present adjusted EBITDA with add-backs for owner compensation, one-time expenses, and non-recurring costs. Some of those add-backs are legitimate. Others are costs that recur every year under a different label.
Test each adjustment against invoices and payroll records, and compare recognized revenue with cash collected. Monthly trends matter too. A strong final quarter can lift the trailing twelve months and hide a weaker year underneath.
Customer Concentration
When a single customer accounts for a large share of revenue, often 10 to 20 percent or more, the valuation depends heavily on that relationship. Review revenue by customer over at least three years, along with contract length, renewal terms, and any change-of-control provisions. A customer who can leave on 30 days’ notice carries more risk than one under a multi-year agreement.
Debt-Like Items
Purchase price is usually set on a cash-free, debt-free basis, so anything that behaves like debt should reduce what the buyer pays. Bank loans are easy to find. The harder items sit elsewhere on the balance sheet:
- Deferred revenue and customer deposits for work not yet delivered
- Unpaid taxes, accrued bonuses, and deferred compensation
- Equipment leases and earnout payments owed from earlier acquisitions
- Pending litigation and open warranty claims
Agreeing on a definition of debt-like items in the LOI prevents a dispute over the same items at closing.
Contract Risk
Contracts determine whether revenue survives a change of ownership. Read the top customer and supplier agreements for assignment clauses, termination rights, exclusivity terms, and pricing commitments. Also confirm that any verbal arrangements with major customers are written down. Undocumented terms are hard to price and harder to enforce.
Setting the Scope Before Exclusivity Begins
Timing is the main constraint once an LOI is signed. Many acquirers bring in buy-side M&A advisory at this stage so the diligence scope is set before exclusivity starts the clock. An outside team can send the right document requests on day one, coordinate accountants and counsel, and flag issues early enough to change the terms.
A short list of priority requests, sent the same week the letter is signed, keeps the process moving while the seller is still engaged.
An LOI is easier to sign when the buyer already knows what the financials support. A first-pass review of earnings quality, customer concentration, debt-like items, and contract risk gives you facts to negotiate with and a clear list of what full diligence still needs to confirm. Buyers who do this work early sign letters they can stand behind.