Getting to an answer through a tailored approach
Insights, information asymmetries, and a proper understanding of an opportunity is gained from due diligence consulting services. “Diligence” comes from the Latin word diligens, meaning “choosing one above the other.” Fundamentally, the due diligence process is all about choosing an outcome (investing) over another (passing). The type and nature of the due diligence (industry diligence, commercial diligence, financial diligence, technical diligence, legal diligence) required varies based on the lifecycle stage of the target, whether it be a pre-revenue startup, or a mature business with stable cash flow.
In this article, diligence in the context of the lifecycle stages, including current and potential best owners is discussed.
Three core lifecycle stages of a company:
- Start-up company: Venture capital investor
- Growth stage company: Strategic corporate investor
- Stable company (or division): Private equity investor
Best owners of a company
Different owners will generate different cash flows from the same business. The value of a business is maximized when its owned by whomever can generate the highest cash flow. Acquisitions serve to illustrate the best owner principle – a seller divests a business to a new owner paying a “premium”, and possibly realizing a higher value through synergies or leverage.
New owners can add value through ties with other activities or companies in their portfolio, such as using existing sales channels to reach additional customers, or sharing their current production infrastructure. Ownership can also add value by providing better governance and incentives for the management team. There are a variety of ways that new owners add value, generally falling into one of the categories below:
- Unique synergies with other businesses
- Specialized skills
- Better insight/foresight
- Improved governance
- Unique access to talent
- Available capital
- Government relationships
- Suppliers, volume discounts or possible exclusivity
- Customers, existing contracts or preferred vendor
The best owner of a company changes over time in relation to it’s lifecycle stage. When pursuing strategic alternatives, the best new owner could be a larger corporation, a private equity firm, a sovereign fund, or an independent public company listed on a stock exchange. Due diligence processes must be custom-tailored to account for the new owner and company stage.
Key diligence questions and concerns for the various business stages are outlined below.
Startup stage company/venture investment: market risk diligence
During the startup stage, the businesses’ founders are its best owners. They have created the vision for the company and worked to bring it to a stage where it may be interesting for other investors. As the company grows it often needs more capital; venture capital firms may be called upon.
In addition to evaluating the culture that the founder’s have created, its also key to evaluate their ability to pivot and adapt to the marketplace. Many venture investments will be minority investments and will not be able to solely install new management. In this case, great attention needs to be given to the management team in place.
Diligence questions for start-ups:
- Is there a market for the product/service being offered?
- Will the company be competing to supply a product that already exists?
- Is this an entirely new product that consumers will need to be educated on?
- Would significant demand exist for this entirely new product?
- Does the improvement the startup brings to market “matter” to customers?
- Is it substantially (10x) better than incumbent solutions?
- Do secular trends look to assist the adoption of the product or service, or get in the way? (E.g. Shift to mobile; shift from ownership to rental, etc)
- Founder evaluation: Do the founders possess these qualities?
- Entrepreneurial drive
- Passion
- Commitment
- Resilience
- Ability to work through failure
Growth stage company/investment: industry risk diligence and commercial diligence
As a company evolves and the industry grows or changes, it may find itself at a competitive disadvantage with bigger enterprises. Regulatory and technological changes may drive stage change as well. Backed by venture capital investors, a company may sell itself to a larger business with the necessary capabilities for continued growth, becoming a product line inside a division of the larger enterprise, for instance. In these cases, manufacturing, sales, distribution, and administrative functions are absorbed into the larger business.
Diligence questions for growth stage companies:
- Is the industry growing or shrinking?
- Are the cost structures improving or worsening?
- Is the industry consolidating? Proliferating?
- If the industry is consolidating, is it fragmented enough to allow for a future roll-up or aggregator strategy?
- What type of scale could other consolidators achieve?
- What type of competitive threats could emerge from others’ M&A?
- If the investment is made, what would the top 2 bolt-on acquisitions be?
- What type of durable competitive advantages does the target enjoy?
- What barriers to entry or competitive moats exist?
- If the target is a leader in the market, how defensible is their position? If a challenger, what’s the gap between the market leader? Does the industry have demand to sustain multiple players?
- How does the company’s products sell in and sell through?
- What are the sales by channel and customer, actual and projected?
- What are the growth bridges, actual and projected?
- How effective are promotions, including depth and frequency of discount?
- What does online competitive intelligence indicate? Product reviews and pricing comparison?
- If the company continues on its proven trajectory, what is the prognosis over the coming years?
Private Equity/Leveraged Buy Out (LBO): financial and operational risk (depending on the investment thesis)
Example stable company scenario: Company is a division within a larger corporation who decides to high grade its portfolio by retaining its higher growth brands, and divesting divisions with less growth. The corporation identifies the division for harvest, and explores strategic alternatives including a public offering, sale to a strategic, or sale to private equity. A private equity firm emerges as a bid leader, based on the amount of debt its able to use in a leveraged buyout.
Diligence concerns for the example company:
Financial risks:
- Capital structure is particularly relevant for LBOs given their reliance on leverage to provide attractive returns
- Will the ongoing sales of the business be stable enough to meet debt repayment given leverage may be as high as 6-7x?
- Given the ‘Worst Case’ in the financial model, does the company experience financial distress, or is it still able to meet obligations?
- Operating financial metrics need to be robust or have a clear reason they could be improved
- Tax structures need to be understood to identify opportunities and risks
- Working capital and debt must be assessed
Operational risks (often driven by post-transaction plans):
- Would the target’s team be expected to stay on or leave (and if stay on, are they capable)?
- Would the deal require doubling down on strategies or stripping out elements that have not generated success thus far?
Customer concentration:
- Does the company derive 10% or more of its revenues from a single customer?
- How would the loss of 2-3 top customers impact the business?
- Are the company’s largest customers financially healthy? Do they often pay on time? Are they health going concerns?
- Is the company’s entire customer list based in a cyclical industry, or sensitive to commodity prices? (e.g. Software companies that sell exclusively to the oil industry experience can see revenue declines with low oil prices.)
Due diligence consulting provides a thorough understanding of opportunities. It’s important to choose advisors who are familiar with the right type(s) of diligence for each stage, optimizing time efficiency during the critically important deal window.
