Due diligence is the first opportunity investors have to do a deep dive into a potential merger or acquisition of a target business.
Most investors have a competent attorney and CPA to perform their legal and financial due diligence. These are assessments of the current legal and financial status of the target and have the principles of law and accounting to guide them. During the legal assessment, a buyer’s attorney will collect all of the outstanding contracts and agreements as well as any outstanding, pending or potential litigation along with all documents that constrain the business. For the financial assessment, the buyer’s accountant will look at the income statement, cash flows and other financial reports in order to verify its past performance. The accountants will look at the financial data for the last 3 to 5 years, depending how diligent the investor is. They’ll commonly ask for independent third-party audits of the target’s financial reports.
In general, financial due diligence will focus on the past performance of the business and legal due diligence will focus on the current status of the business. But what about the future performance of the business? How will this be assessed?
Operations Due Diligence Looks to the Future
The least understood due diligence function (the third leg of the stool) is the operations due diligence and this is where problems are most likely to occur. Most investors start to go off the rails because there are no established principles to guide this activity. There is also little agreement as to what constitutes an effective operations due diligence.
Operations due diligence is an assessment of the target business’ operations infrastructure. It looks at areas like the sales, marketing, IT services, organizational structure and personnel. It should include all operations of the business to give the buyer an idea of the ability of its operating infrastructures to support and grow the business going into the future.
What Is the Purpose of Operations Due Diligence?
Buyers want to know about different aspects of the business. Some want to know about the management team and how it functions in the business. Others want to know more about the sales pipeline and the types of products it delivers. Most investors limit operations due diligence to one or two areas and fail to assess the entire enterprise. For an operations assessment to be effective, it should be approached as an enterprise risk assessment. Investors want to identify any potential risk so they can enter the purchase with their eyes fully open and potentially to support their negotiating points with the seller.
Defining what constitutes the “enterprise” has been difficult due to the lack of a consistent operations management methodology (as exists with law and accounting). Operations Due Diligence — A Guide for Investors and Business addresses this issue further, laying out the principles needed for an effective operations due diligence. In Part II of this article we will discuss each of these infrastructure areas identified in the book.
The goal of due diligence is to discover hidden information about a business. Performing an effective due diligence takes time, resources and money. It’s certainly true that investor due diligence needs to be performed because some business owners intentionally hide information about a business they’re trying to sell. It’s often not what’s said but what’s not said in these situations that you are trying to discover. The Latin expression "caveat emptor" fully applies here — let the buyer beware if they don’t look into their purchase correctly.
Avoiding fraud is not the only reason to perform a due diligence. Just as the buyer wants to ensure things run smoothly and there are no nasty surprises, so should the seller. The seller should perform operations due diligence as a risk mitigation tool.
Due diligence is also a tool an investor can use to discover other vital information about a business. Suppose the investor is trying to discover whether the business fits into their strategic plan — no intentional fraud involved there. Due diligence is an opportunity for the investor to do their homework by determining how well the business fits in with their current operations.
- Is there a culture fit?
- Do your ethics line up?
- Could the sales be improved by integrating the product into the investors existing channels?
- How strong is the market for these products?
- Can you rely on the suppliers to stay after the sale?
- Will the key employees remain after the sale?
These are not the kind of questions your attorney or accountant will ask during the legal or financial diligence, therefore it's important to find someone who knows how to ask these questions (if you don't).
Assessing Risk Is Not the Only Goal of Operations Due Diligence
It can also be used to assess for potential opportunities. If there is some likelihood of an event occurring that could cause the business to fail in the future, then wouldn’t you want to discover this during due diligence? The likelihood of an event occurring in the future that could have a negative effect on the business is the definition of a risk.
Suppose there was a chance the business could win a big contract in the future. Would you want to know about that? An event that could have a positive impact on the business is called an opportunity. Risk and opportunity have been described as two sides of the same coin. If there is a risk that could impact the future sustainability of a business or an opportunity that could greatly improve the business’ chances of success, isn’t that important information for an investor to discover during due diligence?
There is another, equally important, role due diligence can play in a business transaction, which is as an internal analysis tool to prepare for an M&A event. The business owner can benefit by performing an effective due diligence as much as the investor.
Who invests the most in a business? If you look at the commitment of cash, time and reputation, the business owner is generally the greatest investor in a business. If it makes sense for an outside investor to perform due diligence to discover hidden information about a business, then why wouldn’t it also make sense for a business owner to perform internal due diligence to find hidden ways to improve valuation?
Assessing risks and opportunities is the goal of an operations assessment. A business owner should perform an internal due diligence to identify and help mitigate potential risk thereby improving the valuation of the business.
Despite being close to the business, owners rarely know all that there is to know about their businesses. Performing an internal operations assessment will expose areas that need work before a sale and ensure the owner has the most comprehensive understanding possible before entering negotiations. It also helps to prioritize resources for these improvements.
Let’s start with a simple assumption. By finding opportunities to improve the operations infrastructure of a business, we can improve the valuation of the business. If, for example, an owner performs an assessment of the sales infrastructure and determines there are affordable things that could be done to improve their sales process (and therefore their projections), then as part of positioning the business for sale, it would seem to make sense to make the changes before speaking with an investor.
In my book, Moving On – Getting the Most from the Sale of Your Small Business, we look at the use of an internal operations assessment (and other things) as a tool for increasing the valuation of a business. “Smart business owners perform an internal due diligence both to find ways to improve the business and to avoid surprises during an investors due diligence.”
In Part 2 of this article we will describe a structured approach to operations due diligence.