It’s been a year since my book "Operations Due Diligence - An M&A Guide for Investors and Business" was first published by McGraw Hill. In that year, I have had the opportunity to speak with many investors and business owners about this subject. These conversations have further validated my earlier findings; that there is very little common understanding of the role of due diligence as an M&A and business analysis tool. Most people approach this critical event with an ad hoc, seat of the pants, "check the box" attitude. Much of my time over the past year has been spent educating investors and business owners about the benefits of performing an effective due diligence. When I was writing the book, I didn’t realize how radical my ideas might seem.

Our Traditional View of Due Diligence

Let’s start with what should be the easiest question: "who should perform due diligence?" Both investors and business owners can benefit by performing an effective due diligence. I can almost hear your heart racing from here! No, no, no Jim… The due diligence is for the investor. The business owner is just a participant. Really? Well consider this. 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 a due diligence to discover hidden information about a business, than why wouldn’t it also make sense for a business owner to perform an internal due diligence? I’ve spoken with so many groups that I can hear your question from here! "But, but, but… doesn’t the business owner already know everything about his own business?" "What would be the point?" That is a common misunderstanding that stems from the lack of understanding about the benefits of using due diligence as an internal assessment tool. Let’s start by looking at the M&A due diligence everyone is familiar with.

The assessments most people are familiar with are the legal and financial due diligence their attorney and accountant perform during an M&A due diligence. They are an assessment of the current legal and financial status of a business that is being acquired. When you perform a legal or financial due diligence, your accountant will look at the income statement, the cash flows, and other financial data. You will also collect all of the outstanding contracts and agreements needed to allow your attorney to assess the legal status of the business. You will want to look at the data for the last 3 to 5 years depending on how diligent you are. Legal and financial due diligence have the principles of law and accounting to rely on, and a competent attorney and accountant can perform these assessments without too much trouble. These assessments will tell you the recent history of the business and the legal and financial status up to the day of closing. Notice the past and present tense of these assessments. What else do you need to know about the business? This is where most people start to go off the rails.

Due Diligence is a Voyage of Discovery

The goal of due diligence is to discover hidden information about a business. Performing an effective due diligence will take time, resources and money. It’s certainly true that 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, avoiding fraud is not the only reason to perform a due diligence. "Let the buyer beware" indeed, but fear of a dishonest seller isn’t the only benefit of a due diligence.

Due diligence is also a tool that 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 assessing how well the business fits in with their current operations. Is there a culture match? What about an ethics match? 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 stay? Are these the kind of questions your attorney or accountant will ask during a due diligence? In strategic acquisitions, where the buyer may be a competitor, the use of due diligence is occasionally used by less ethical people to gather information about the seller with no true intent to buy the business. In these cases, let the seller beware! Assuming the buyer is genuine, what other information might they need to know about the business?

In my presentations, this is where most people raise their hands and start to go "Ooo, Ooo, Ooo… Pick me… Pick me." "Management, we want to know about the management team." "Sales, we need to know about the sales pipeline." "Products, we assess how well the product works." I generally let this run on for a while (depending on whether my presentation is running ahead or behind schedule) and finally ask; but why? What are you looking for in these? "Well, if they have an incompetent management team the business could fail." "If they’re not making sales the business could fail." "If their product doesn’t work the business could fail." "Could fail"… That’s future tense. Now we may be onto something.

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 your 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 businesses chances of success, isn’t that important information for an investor to discover during the due diligence? We assess these risks and opportunities as part of an operations due diligence. A business owner should perform an internal due diligence for the exact same reason! To discover what latent risks and opportunities exist within their business.

Due Diligence is a Risk/Opportunity Assessment

Operations due diligence is a risk/opportunity assessment to determine the future sustainability of a business. "Business operations" is a very broad, rather generic term that doesn’t have strong disciplines like law and accounting to base an assessment on. That is the primary cause of M&A failures and poor enterprise risk assessments. An effective operations due diligence requires a structured approach rather than the ad hoc methods used by most investors and businesses today. In Part 2 of this article we will describe a structured approach to operations due diligence.