Tips for Conducting Due Diligence in Private Equity

When I first started doing this work, I’d just do what the Client asked for. Until I had this case: We once had a Client invest $XX million in a company where the Client wanted to go fast and only focus on red flags - a basic check list to get the deal over the line. Six months later, all hell broke loose: - Payments delayed with flimsy excuses - Partners complaining about breach of contract - Promises of buying inventory that never happened Turns out, this company had a history of fleecing partners. And now our client was tied to the mess and had to clean it up. What I learned: A track record of burning bridges won't show up on a check list approach. Sure you might be able to find some litigation in the public record, but the company could chalk that up to the normal course of doing business. To catch these problems, you need to dig deeper: 1) Reference checks with past partners, not just the cherry-picked ones 2) Litigation searches for contract breaches, judgements, complaints. Where litigation databases are not available, do the manual records retrievals (despite some taking up to 2 weeks). Where even that is not available, do discreet source inquiries! 3) Forensic analysis of financials for cash flow issues or payment inconsistencies Real investigative due diligence means vetting how a company operates inside and out, and preventing surprises from showing up. #dealintelligence #duediligence #PrivateEquity #mergersandacquisitions

Getting a clear snapshot of a business's financial health early on in your diligence process is key. But, how do you do that without coming off as too nosy right out of the gate? Here are some smart, subtle strategies to get the info you need. 👇 First off, start with the basics. Chat about the business's history, its journey, and where it's at today. This can give you clues about stability and growth without directly asking for numbers. Secondly, talk about the team. Ask about how many people work there and their roles. A growing, stable team often points to a healthy business. Also, if the team is 1-5 people, it's a good indication that the business is too small financially. Next, gently bring up the topic of customers. Discuss who they are, how they've grown over time, and what keeps them coming back. Happy, returning customers usually mean a business is doing something right, financially speaking. Then, shift to discussing the products or services. What's been a hit? Are there any new offerings in the pipeline? This can hint at innovation, adaptability, and potential revenue streams. Also, casual conversations about the industry can provide context. Ask about trends, challenges, and opportunities. How a business navigates its industry landscape can reflect its financial savvy. And don't forget to explore future dreams. Where does the business owner see the company in a few years? Ambitious yet realistic plans can signal financial health and growth potential. Lastly, make the ask on their financials. What is current revenue? What was it in 2021, 2022, 2023? What did they take home personally last year? It seems like it would be awkward to ask, but you'll be surprised how forthcoming business owners will be on the subject. (Note: Some searchers like to move this much earlier in their call scripts.) Remember, these conversations should flow naturally. The goal is to build rapport while piecing together a picture of the business's financial health, without putting anyone on the spot.

My new friend Pat Linden inspired me to write this post. He wrote a great comment to one of my posts and I’d like to expand further. Skimming the surface of contracts in M&A is a common pitfall. Here’s a list that highlights the depth and details that need attention during due diligence and transition: 1. Contractual Obligations: Detailed review of all obligations, including termination rights, penalties, and liabilities. 2. Expiration and Renewal Terms: Understanding the timelines for renewals and the implications for the merged entity. 3. Compliance Requirements: Ensuring all contracts are compliant with current laws and regulations, including data protection. 4. Financial Commitments: Assessing ongoing financial obligations, including lease agreements and service contracts. 5. Intellectual Property Rights: Evaluating the ownership and usage rights of intellectual property mentioned in contracts. 6. Vendor and Customer Dependencies: Identifying key relationships that are crucial for business operations. 7. Change of Control Provisions: Checking for clauses that could trigger adverse effects or require consent upon change of control. 8. Dispute Resolution Mechanisms: Understanding how potential disputes are managed within the contract framework. 9. Confidentiality Agreements: Ensuring sensitive information is protected during and after the M&A process. 10. Integration Feasibility: Evaluating how easily contracts can be integrated or transitioned into the new business structure. This level of detail in contract analysis is important for a successful M&A transition, going far beyond the big picture to ensure smooth and compliant integration.

Most investors would’ve overpaid by $500,000. They didn’t even know it. Here’s what happened: We were underwriting a multifamily deal in Charlotte. On paper? It looked solid. Great location. Decent cap rate. Pro forma was clean. But when we dug into the contractor bids? One number felt off. Really off. We brought in our own subs. Did the walk-through. Compared scopes. Turns out—the GC padded $500K in unnecessary upgrades. That’s half a million in investor equity… Gone, if you don’t catch it. We renegotiated. Tightened the CapEx. Saved the deal. Increased projected returns. Due diligence isn’t a checklist. It’s an edge. • Verify the debt terms • Scrutinize CapEx bids • Audit the rent roll • Understand the tax position • Know who is underwriting, not just what This is the work most “passive” investors skip. It’s also why they lose money. If you don’t have time to do this level of diligence? Find a partner who does it like their own capital’s at stake.

This week I’m pumping out a series all about educating founders on the capital markets from pitch to close. Ep. 1: What is PE & VC (linked below) Ep. 2: The Pitch (linked below) Ep. 3: (This one) ‘The Due Diligence Process’ Ep. 4 (next one): The anatomy of the term sheet Let's get into the due diligence process 👇👇 So let’s assume you’ve been reading along, pitching the right folks, and you have some interested investors. Time to go into the ‘diligence phase’ where investors will dig in deeper and you will educate them on your business in hopes of getting that sweet sweet term sheet. 1) What to expect in diligence Expect a deep dive on your business. The biggest thing to remember in this phase is that less is ALWAYS more. At this point, investors are mostly looking for reasons to say no, and the more information you give them, the more likely they are to find that reason. Now, this is not to say you should withhold information from investors, but you definitely do not need to perform every ad hoc analysis they ask you for. 2) What should you give investors This leads me to what actually is appropriate for investors to request from you. The list is a bit smaller than you think. Definitely ok: Historical financials, pitch deck, cap table, org chart, financial model (critical) Fine: cohort data, product roadmap, supply chain details Do not provide pre-term sheet: ad hoc requests, internal reporting KPIs, employee details/time with investor. These are not required to make an investment decision 3) The financial model ❤️ The easiest way to get passed on by an investor is to have an unimpressive financial model that you don’t know well. It shows you cant tell the story of your business in a measurable, quantitative fashion. Your financial model should be super detailed, with schedules/models forecasting each part of your business. I.e., if you sell shopify, amazon, and wholesale, each of these channels should have their own models that roll up into a consolidated P&L. Expenses should be ‘bottoms up’ in your model. No “% of revenue” forecasts. COGS should be bottoms up and show unit sales by product, payroll should be bottoms up and show expenses for each individual employee A well thought out and articulate financial model is the key to success in fundraising. Financial models look like a wall of numbers, but to us finance folk it is a beautiful wall of words that make sentences that create a story. Be able to tell that story from the beginning of ANY chapter. 💡 DM me for CPG financial modeling help. This is far and away the most critical component 4) The follow ups Once you’ve done your intro call and pitch and provided diligence items, its ok to take another call or two with the rest of the firm. Remember though, you are not pitching this time. You are walking them through some of the questions they have. If you find yourself pitching again in a follow up meeting, you’ve already lost.