Before making an investment or closing on an M&A deal, conducting due diligence on the target is a critical step.
There are many levels of diligence, ranging from preliminary diligence (sometimes as quickly as 2-3 days’ work) to comprehensive diligence (can involve hiring external firms and run 6-8 weeks or longer).
One challenge I often come across is the tendency to over-analyze or to go down the wrong rabbit holes.
The investor or acquirer asks for a list of diligence items 100 items long. The target provides access to a large data room with dozens of files.
❌ And when confronted by all the information, the investor goes digging into areas that DON’T lead to better investment decisions.
✔ Here is a framework I like to use when starting due diligence to keep things in perspective.
First, I think of diligence work as either
(1) protecting the downside by identifying and mitigating risks that can surface post-close and
(2) maximizing the upside of the transaction by either identifying or refining revenue and cost synergy items
Second, instead of the focus being for the team to grind through reviewing hundreds of files, it is more productive to thinking of this as answering some key questions as a result of the exercise.
If a functional or commercial lead cannot answer these types of questions at the end of the diligence process, either the focus has been on the wrong areas or the target has not organized the responses well.
The list below is somewhat loose, and is not meant to be exhaustive but helps to set guardrails so that we ask and answer the right questions.
Terms in [ ] denote areas in a common diligence list.
Here goes (credit to colleagues and connections who have helped to enhance this list).
Do we understand precisely how the business makes money? Can we explain it to a smart teenager? (and if the answer to this has ANY jargon, we likely don’t, and need to ask more questions) [Financial, Market, Product, Pricing, Customers]
Do we know why the business will keep making money, and more of it, in the future? [Strategy, Financial – margins, and financial ratios]
What end-user problem does the product fix better than other solutions in the market? [Product, Competition]
Will the current team get us to the desired state and will they stick around for the journey? [Management, People, HR]
Can the business add paying customers quickly, and can it do so without spending a lot? [Go to market, Sales and Marketing]
Will the business be able to defend and expand its role in the marketplace? Or can someone easily replicate what the business does? [Intellectual property, Technology, Customer contracts, Pipeline]
Can we operate the business as we intend? Are there any minefields? [Legal, Organizational, Antitrust, Regulatory, Cyber]
Will the business thrive under our watch? [Culture, Synergies]
Are there any external factors (economic, industry, etc.) that threaten the continued success of the business? [Strategy, Market]
Can we afford the investment? [Valuation]
If the answers to the above questions are favorable, move on to the next phase or expand the diligence.
If there are too many red flags, it might be right to cut loose.
Many areas didn’t make this list (e.g. tax, real estate, procurement, ESG, cyber) but depending on the specific business, those areas might need to be bubbled up.