So you've identified an acquisition target and are ready to be a CEO?
Before you take that final plunge into the C-Suite, however, you need to make sure the business you think you are purchasing is actually the business you are buying. Also known as, search fund due diligence.
Due diligence is the process of evaluating a company and its many facets in painstaking detail so that everyone involved in the investing process has a profound understanding of the business. When pursuing entrepreneurship through acquisition, diligence is quite frankly the most exciting part.
Preliminary Diligence vs. Confirmatory Diligence
Diligence in search fund deals has two major steps: preliminary and confirmatory.
Preliminary diligence covers all research and examination done before an offer to purchase is shared with a business owner. What you uncover during this step is then used to craft a letter of intent. Fortunately, submitting an LOI comes with little cost or reputational risk. Unfortunately, LOIs still require time and should demonstrate both your in-depth knowledge about the business you are looking to buy and your good intentions, otherwise, the seller may not consider you as a potential new owner. Additionally, this pre-LOI stage has implicit opportunity costs and future ramifications. A searcher would not want to end up losing future time and money by moving too quickly to the confirmatory diligence step with a target that would have failed preliminary diligence tests.
In the grand scheme of things, the preliminary diligence step serves to gauge seller character and motivation, build a relationship with them, and determine a fair, non-binding offer price.
Confirmatory diligence begins after a seller signs the LOI. If preliminary diligence focuses on digging into industry and business operations, then confirmatory diligence allows you to go deeper into specific content areas— eight to be exact (financial, legal, customer, technological, human capital, operational, other).
- Financial: confirms the truthfulness of the seller's historical financial statements and makes adjustments for projection value. It gives an idea of the company's earning power and influences the final purchase price and deal terms. Could also determine whether the entrepreneur should even complete a deal.
- Legal: evaluates the legitimacy of current owner's identity and ability to deliver on company's past promises. This diligence directly correlates to transferring ownership and building transaction terms.
- Commercial: uses public resources and paid databases to evaluate industry health and industry position compared to competition.
- Customer: analyzes customer data and perspectives to understand which customer needs are being fulfilled and gauge current and prospective customer loyalty.
- Technological: develop key beliefs surrounding company's vulnerability to inept technology and the people administering technology tools.
- Human Capital: uncovers owner's motivations to sell, explores issues of employee retention or incentives, identifies top performers and contributors, and examines company culture through surveys and interviews.
- Operational: understand the step-by-step process required for business to work and evaluate time and cost efficiencies in the customer service.
- Other: rely on industry experts to answer crucial questions for running a business in niche areas, such as environmental and insurance.
Because you are looking to challenge existing assumptions, reframe perspectives, and attempt to uncover any red flags — all while building a rapport with the seller — you will start to incur expenses by relying on financial, legal, and other third-party advisors.
Search Fund Due Diligence Strategies and Tips
Navigating business acquisitions and mergers is a daunting task. Luckily there are strategies and tips that can help guide your search fund due diligence process.
Key Bets
Key bets are at the core of all investing decisions. They serve as a compass that helps searchers identity and prioritize actionable items. Key bets are reasonable must-have features that drive value for the current company. For example: customers, market segments, people, stock, and inventory. A way to help identify 8-12 key bets is to reflect on why you fell in love with the business in the first place.
Once key bets are identified, searchers can directly prioritize the due diligence tasks.
Relationship Management
Due diligence requires outstanding relationship management with all of the parties involved: the seller, capital providers, and advisor networks.
When dealing with sellers, be weary of seller burnout. More often than not, owners are selling their business for the first time and are uninformed when it comes to the due diligence process. Mix that knowledge gap with in-depth questions, unknown motivations, and possible fear of letting go, and it is a short fuse. Keep it professional first, with pleasant face-to-face meetings and patience, and you should be good to go.
When dealing with capital providers, quality and frequency of communication are important. Sharing diligence milestones with those with financial stake is crucial to your future acquisition's success. Luckily, working with a bank instead of a group of investors limits the responsibilities of the searcher when it comes to ongoing relationship maintenance.
Finally, when dealing with advisor networks, you must be strategic on which third-party servicers you employ. The costs they run add up, but the added benefits pay for themselves. They are a great resource when it comes to speeding up diligence tasks / curbing seller cold feet, picking up on red flags, utilizing toolkits that the searcher often does not have access to on their own, and serving as a stamp of approval. That stamp of approval goes a long way in appeasing capital providers as well, making that relationship easier to manage.
What's Next?
If you are looking for a deep dive into the role due diligence plays in your search fund acquisition, you can check out the full article covering due diligence best practices written by Yale School of Management graduate Andrew Seth Jacobs and Professor A.J. Wasserstein.
Additionally, Security's very own President, Andy Schornack, will be working with the team at Showcraft for this year's Twin Cities Startup Week on the panel discussion Skip the Startup: How to Buy and Build a Company Through Acquisition Entrepreneurship. "Everyone thinks that the only way to innovate and disrupt an industry is to launch a start-up. We think that’s wrong. Acquisition Entrepreneurship is an emerging global movement that empowers entrepreneurs of all backgrounds to transform companies and industries through strategic acquisition of small businesses. In this session, you will learn more from local players in the Acquisition Entrepreneurship space who will give you the tools and connections to skip the start-up and buy and build a company instead."
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