Early stage FDD red flags

It is important to identify potential red flags early in the diligence process to efficiently eliminate targets that do not meet your investment criteria, avoiding unnecessary time and resource expenditure. In our experience, most targets fail one or more of the following tests: 1. Cash Proof of Revenue: Anticipated sales based on the QofE provider’s calculations do not align with reported figures, and management is unable to explain or reconcile the variances. 2. Other top-line issues: We often see SMBs recording non-recurring and non-operational income in top-line accounts. Once these items are adjusted out, EV often is (significantly) overstated. 3. Seller EBITDA/WC adjustments: Seller or their advisor must be able to provide supporting documentation for ALL adjustments. In some cases, sell-side advisors use unrealistic estimates, hardcoded figures without support, or overly aggressive adjustments. Verifying and analyzing these adjustments is not only critical for valuation purposes but also serves as a strong indicator of the sell-side advisor’s quality. 4. Cash Flow Modeling: We all know “Cash is king.” Many targets appear profitable in the CIM and even on a reported cash flow basis. However, once modeled on the go-forward capital structure, the cash flow picture often changes. Many targets carry no debt pre-close, yet their cash flow cannot support the post-close SBA debt burden.