Your Company’s CEO calls you Friday evening to inform you that a third party is interested in either funding or purchasing your Company. The CEO tells you that this third party has sent him a ten page document requesting a list of key information about your business and its operations (capitalization table, financial statements, key contracts, etc.). He asks if you can provide the information by Monday.
As any experienced leader who’s ever gone through a financing or acquisition will tell you, things can get brutal when people are forced to fight for their economic lives. Yet many management teams do not prepare for these events. Much of this neglect is due to inexperience. Many founders and employees of startup companies today are just out of school. They have never been buried under a cannonade of questions or requests coming from potential investors. Much of the neglect has to be due to the overbearing workload of solving day-to-day problems. Management teams often overlook marketing themselves to financial customers, while they spend sixteen hours a day selling themselves to customers of their own product. Focusing on your customers and your market may help you avoid crashing the car, but no matter how well the car performs, it will be useless if it run out of gas.
The solution to an unanticipated request for information from a potential investor or buyer is to perform due diligence on your own company in advance. When performed correctly, due diligence is a disciplined, deliberate collection of information that demonstrates that management understands their market, their customers and products, their organization, and their strategy. Organized diligence gives a summarized view of all processes and inputs needed to deliver products and services to the customer. Finally, it fosters an awareness and understanding of a company’s operating environment while also preserving key organizational and operational secrets.
To perform due diligence is an opportunity to probe into your company from the perspective of an outsider. Throw yourself into full investor mode: Does the information provided accurately depict how systems and processes work today? Do you see any capability gaps in the team? Are there pieces of the company strategy that urgently need to be addressed? Can you identify and understand the drivers and root causes of revenue and cost (including offerings, customers, suppliers, processes, internal systems, and distribution channels) as well as their interrelationships and the ultimate cost complexity they create? Which key people or information do you need to protect?
Diligence is more than a collection of contracts, financial statements, tax returns, compensation plans, compliance documents and close packages. Your teams are being evaluated through these products. From a back office perspective, you want to demonstrate that as much craftsmanship goes into these products and the processes used to create them as what goes into developing your website. Diligence is also an opportunity to review your incentive structure. Are your key performance indicators tied a to strategic direction. If a transaction were to occur, which parts of the company are incentivized to embrace change and which will be doing business as usual or looking for a new job?
When it is done well, as it should be for any enterprise with aspirations of growth, due diligence is an ongoing process. Your business environment is always evolving and so must your diligence package. Does it demonstrate how the company plans to maximize its current opportunities? Updating the package is not difficult. Once the management team has decided on a set of diligence questions and requests for documents, have an intern or assistant gather the documents and place them into a virtual data room. Organize the data room by function (e.g., HR, Finance, Legal, Information Technology, Business Strategy, Marketing, etc.). Make sure access is limited to the data room and a record is kept of which documents are reviewed and who reviews them. Then have the intern update the data room periodically to refresh or replace stale or outdated information.
A well organized diligence package fits like a glove into the demands of a financing or an acquisition. It needs to. For nearly every year that a company does business, some kind of deal will be presented to management. If your package is not complete, you will scramble to pull data together and miss out on or delay other critical work. There are 720 hours in a week. During deal negotiations, you can fill nearly every one of them for several weeks with integration plans, pro-forma cap tables, drafts of term sheets, as well as your everyday duties. If you are not the potential acquirer, nearly all of this time is dictated by the other party. Your value will rise during this period if the other party recognizes that you are prepared and your package is well crafted. It will fall if you are wasting time doing the work of an intern and holding up the deal.
- Have you prepared a due diligence checklist and package for your own company? Has it been updated with current information?
- Is your capitalization table up to date? Have your attorneys and your internal finance and legal team reconciled the data in your cap table to your internal system data and to your employees’ personal files?
- Has your financial plan or budget been updated with recent information? How far into the future (e.g., one month, one quarter, one year) does your plan extend?
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