Execution of phases I & II
The first two phases (I & II) must be executed from within the running installation of Windows that is to be prepared for being started from USB. Usually this installation will reside on an internal harddisk or a virtual disk of some virtual machine.
It is definitely not possible to apply neither phase I nor phase II to an offline installation as both phases make use of some of Windows' builtin internal APIs that will only operate on the running installation itself.
Execution of phase III
By default the files of the installation that has been prepared in phases I and II will be transferred to the USB device as the first step of phase III. Alternatively they may also be copied by some other suitable means. However it is strongly recommended to prefer USBoot's internal routines as they will try to preserve some of the installation's characteristics that will get lost during a plain file copy (and even disk imaging tools may not work as expected in certain configurations).
In any case for reliable operation it is mandatory to execute the remaining steps of phase III before actually trying to boot from USB no matter in which way the installation's files have been transferred.
In contrast to phases I & II it is not required to run phase III from within the installation of Windows that is to be prepared/transferred.