Do Your Homework: Why Every CEO Needs To Know How To Do Due Diligence

December 19, 2019

How To Do Due Diligence

As Ronald Reagan said, “Trust, but verify.”

Every responsible and effective CEO needs to have a process in place for the various decisions that come across his or her desk. Whether you’re looking to onboard an individual into a critical role, engage in a new partnership or enter into an investment opportunity, an established and reliable due diligence process will guide your decision-making framework and ensure you reach the optimal conclusions to the best of your ability. But what does due diligence mean?

How Is Due Diligence Defined?

Due diligence is the steps undertaken to investigate a business situation (HR, acquisitions, contracts, etc.) prior to a decision being made. It can involve the review of financial records, personal background information, legal history, deal structuring and valuation, and more.

Due diligence in equity investment can include a thorough review of revenue and cash flow, historical price fluctuations, competition, the status and history of issued stock options, the company’s balance sheet, its quality of earnings, its contracts and leases, an investigation for undisclosed liabilities and more. You may not have easy access to all of this information, and an individual investor is certainly not required to go through this process, but the more thoroughly you review up front, the better prepared you will be to make a wise decision.

In a similar vein, if you’re performing due diligence for a hiring or partnership decision, I recommend at least auditing the individual’s social media presence, running LexisNexis searches and possibly having the person (or persons) take a personality profile. So in addition to assessing their books and verifying proffered financial data (if applicable), I want to make sure their personality is going to mesh well with mine and my team as we move forward.

Protecting Yourself With Due Diligence

The same holds true when you want to make an investment in a company. Say you’re in a deal negotiation for an investment in a company that lacks a proper succession plan. Until you get in and develop a succession plan, you need the principal owners to stay on at least in a credible advisory role, because they know the industry and the business well — and you don’t, yet. Even if their role will be less operational and more strategic, you need to be sure that their personalities won’t clash with yours.

Just as importantly, getting to know them will let you understand their work ethic better and have a level set of expectations. In a situation like this, when you’re going to hand them a big check up front, you want to understand and evaluate whether you think that money is going to change them afterward. They may work really hard now, but before you give them $5 million for their company, you need to be sure they won’t take the payday and go hit the beach, leaving you hanging.

When you’re writing a contract, you can and should include clawback provisions. It’s always wise to cover yourself contractually against someone acting in bad faith. Even so, as soon as you have to go back to a contract and refer to it very specifically about how you need to act, you know you’re in trouble. It will get messy and usually will involve lawsuits, and there are certain to be disagreements about the meaning of words in contracts.

In this circumstance, a thorough due diligence process hopefully sets aside the need to go back to your initial foundational documentation in most situations. It may still happen eventually — even lifelong friends can have their relationships ruined over a soured business deal. But if you conduct due diligence up front and thereby avoid having to exert your contractual governance control, you will save yourself a lot of headaches down the road.

When Should You Conduct Due Diligence?

In any kind of contractual relationship, whether it’s a key vendor or supplier, a customer or someone you’re going to joint venture with, you will benefit from a due diligence process. And sometimes that process involves more than just investigating one individual or company; maybe performing due diligence in a given situation requires a clear assessment of your own capacity, the reality of your business and your ability and willingness to pursue a potential opportunity.

Think about it this way: Pretend you run a medium-sized consulting company, and you have an opportunity to triple the size of your business with one client. It’s a high-risk, high-reward situation, because you’re putting a lot of your eggs into one basket. If it pans out, you’ll be set up well for the next few years. But you’d better make sure that customer’s not going to flake on you once you’ve put steel in the ground.

You always need an exit strategy. Put your risk manager hat on and decide if this is really a good situation — because it might be too much of a good thing. If you take this deal, you’ll likely need to work really hard to get more small and medium-sized clients to go alongside it. And in the end, two years from now that client might be sold to another company with its own in-house expertise.

It is a risk, but your internal due diligence process can help you determine whether the benefit of two years of a good run is worth it. If you take the opportunity, maybe your business can throw cash to the bottom line and then hoard it, building a runway to weather the loss of that major client.

But you also need to understand your internal stakeholders and make sure they will be on board, too. It might be worth bringing on some additional employees to manage the workload, balancing one major account with a subset of smaller clients. But it might require running for two years with a much higher capacity utilization, with your staff feeling the strain of that.

There are no easy answers in a situation like this, which is why a thorough due diligence process is so critical for a CEO or other decision-maker to have in place. You need to be able to probe deeply on issues pertaining to any opportunity that arises, internally and externally. If you’re in a situation where you need to conduct due diligence and could use some guidance, or if you want to establish a due diligence process checklist so you’re prepared in the future, reach out and let the principals of Percipio Partners help. We’ve been down that road many times before, and we’re always ready to share our expertise.

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