Due Diligence

Areas of Due Diligence

A crucial part of the investment process is the due diligence performed on the company. Think of it like an investigation process for a potential investment: Cicero will perform very detailed due diligence in order to ensure that they are making a sound investment.

This process is crucial to the success of the investment, and the financial sponsor must look at all critical aspects of the target company: commercial, financial, and legal.

The vast majority of the time is spent on commercial due diligence while the financial and legal areas are more confirmatory in nature. Cicero relies on consultants for their expertise and advice for portions of the due diligence process, but ultimately the investment decision is the firm’s responsibility. This section provides questions and topics that are often evaluated while looking at an investment opportunity.

Commercial due diligence includes understanding the company’s value proposition, market position, historical performance, and industry trends in order to assess the target’s ability to achieve its forecasted projections.

Review Historical & Projected Financial Performance

Financial due diligence confirms that all the financial information provided is accurate and helps us understand some of the unique dynamics of the company from a financial reporting perspective. The firms typically hire accountants and/or auditors to review the financials, operations, customers, markets, and tax issues in detail. This is usually referred to as “transaction advisory services.” This analysis provides a deeper look into the company’s historical performance in order to understand how realistic the company’s forecasted projections are. Provide a comparison of the historical performance to the management budgets for the last 5 years. Describe the methodology behind the budget and the reasons for beating/missing the budget. What are the key performance indicators (KPIs) the management uses to monitor the business? Describe the trends in these indicators. Break out your organic growth over the last 5 years (not including the impact from acquisitions). Provide your 5-year financial model and describe the key drivers in your projections.

Growth

Please describe key assumptions. How does it compare to expected market growth?

Where will it come from (increase in price, increase in volume, increase in market share, new products, acquisitions, etc.)?

Margins

Please describe key assumptions. Why (for example) do you expect margins to increase so significantly compared to historical performance?

Where will it come from (operating leverage, cost efficiencies, higher margins on products, revenue/cost mix, etc.)?

KPIs

Describe key assumptions. How do they compare to the industry average and/or your main competitors?

What are the primary risks to this forecast (new product introduction, successful expansion into new geography, customer concentration, sufficient hiring of employees, R&D resources, etc.)?

Due Diligence Questions

Competitive Landscape and Market Position

It is important to understand how sustainable the target’s business model is and where it is positioned relative to its competitors.

What is your competitive advantage (e.g. product offering, technology, price, premium brand, distribution capabilities, geographic presence, fully-integrated solution, etc.)?

Is this a disruptive business model (i.e., one that changes the landscape of how business is done in this space in some way)?

What are the barriers to entry into the business?

What are the costs of switching to a competitor’s product?

Where does the company fit in the industry value chain?

How has the industry changed over the last 5 years?

How do you expect that to change over the next 5 years?

Who are your main competitors?

From whom have you been gaining/losing market share?

What firm is the biggest threat to your company?

What is the biggest share gain opportunity?

What is the market landscape (e.g. oligopoly, fragmented market, first-mover, etc.)?

How saturated is the market?

Industry Growth / Addressable Market

When evaluating the industry, it is crucial to understand the market environment and the external factors affecting the business.

What is the historical growth of the market?

What is the projected growth of the market over the next 5 years?

How mature is the industry?

What is the total addressable market?

What segments of the industry are growing faster than others?

Describe the key macroeconomic drivers of the business. What are the trends?

Have there been any significant changes to the industry landscape (e.g. disruptive new entrants, consolidation, vertical/horizontal integration, demand/supply imbalance, etc.)?

What are the regulatory concerns and how can it adversely affect the business?

Customer Base/Suppliers

This entails understanding the “stickiness” of customers and the company’s reliance on suppliers.

How many customers do you have?

What is the concentration of your top 50 customers?

What is the typical contract length of a customer relationship?

What is a typical renewal rate?

What percentage of customers have multiple products?

Who are the key decision makers for the customers?

What are the buying dynamics?

How long is the entire sales process?

Please describe your most recent customer wins and losses. What were the main reasons?

How many suppliers do you have?

What is the concentration of your top suppliers?

How large of a customer are you to them?

What is the average length of the relationship?

How often are your supply contracts renegotiated?

If you receive price increases from your suppliers, are you able to pass it through to your customers?

Capital Requirements of the Business

A good understanding of the total capital needed to run the operations of a business is needed, especially during difficult times.

How capital intensive is the business?

What percentage of capital expenditures is growth capital vs. replacement/maintenance capital?

How has that trended over the last 5 years?

What kind of lead-time is needed (i.e. time from purchase order to delivery) when making a purchase order?

How cyclical is the business?

Are there any severe seasonal changes in demand? What are the factors?

What are the factors?

How much visibility do you have in expected sales?

What percentage of the companies cost structure is fixed vs. variable?

What is the breakdown of operating expenses?

What is the normal working level of cash to run the business for a year?

At what manufacturing capacity is the company running right now?

How quickly and to what extent can it be reduced if demand falls?

What would be your biggest concern in a downside scenario?

Answer These Questions