The Importance of Operational Due Diligence

There are four required diligences that must be performed by at all M&A closes. Operational, Financial, Legal, and Tax Diligence. In this article, we will discuss the importance of Operational Due Diligence, Operational areas of review, and how to use Operational Due Diligence.

• Operational Diligence: Review of Business Processes including Risk, Sales & Marketing, Supply Chain & Operations, Finance, Customer Service, Data & KPIs, Technology, Team & Human Resources

• Financial Diligence: QOE (Quality of Earnings) that includes validation and analysis of historical financials (P&L, Balance Sheet, & Cash Flow) and EBITDA adjustments. A QOE is required for Lender underwriting

• Legal Diligence: In addition to work & negotiation of closing documents, legal due diligence focuses on the review of formation documents, shareholder agreements, capitalization tables, contracts, compliance, disputes, IP (Intellectual Property)

• Tax Diligence: Ensuring all Federal, State, Local, Employment, and Sales taxes are current. Additionally, Tax Diligence verifies Accounting methods, ensures there is no outstanding liability, and compliance with Federal & International Laws.

Why Operational Due Diligence & How It Can Be an ROI Launchpad

Financial, Legal, and Tax diligence are past looking, meaning has the company you want to acquire been transparent in the sale process and have they accurately represented themselves. The past looking diligence also attempts to uncover red flags from the past including misrepresentation of earnings, legal issues, or tax compliance problems. Often, the red flags in financial, legal, and tax are deal killers leading to insurmountable legal or underwriting challenges.

Operational Diligence is very different. Operational diligence is about the future. It documents if the business you are acquiring has the capacity to, at minimum, maintain current earnings. Additionally, Operational Diligence establishes how quickly your new acquisition has the potential to grow. The consequences of not maintaining current earnings can be bad. It means cash flow will be tight or there is potential for not paying your business loan or payroll.

While the consequences for scaling quicker may not be as severe as maintaining current earnings, there is a massive ROI effect.

Let’s review an example:

• Company 1: The business on the surface looks good, but limited Operational DD fails to expose the many business processes need to be overhauled

  • Acquired for $4.0M at a 4.0x multiple

  • Searcher conducts their own diligence focused only on red flags and misses a lot of the business process issues

  • Not enough time to focus on business process

  • Multiples not adjusted during Due Diligence

• Company 2: While not set-up for immediate scaling, has great business practices in place and a capable team

  • Acquired for $4.0M at a 4.0x multiple

  • Operational Diligence completed correctly focusing on both red flags and business processes

  • Buyer now has a comprehensive set of data that can be used to execute directly from the start

  • Diligence Group gave a roadmap for growth

  • Scaling can start in year 2 and can further increase in year 4

Growth Metric	Company 1	Company 2
Five Year Growth	12%	68%
Five Years Total EBITDA	$4,868,370	$6,616,811
Year Five EBITDA	$1,121,670	$1,680,236

ROI Analysis

• Company 1 was a turnaround, which was not revealed because limited Operational DD was completed. Company 1 was acquired at a 4.0x multiple. Company 2 had better business processes, Operational DD was thoroughly completed and was purchased at a 4.0x multiple

• Company 1 has the famous J Curve. Company 2 does not have the J Curve

• ·In five years, Company 1’s multiple is the same and Company 2 gained an additional turn

• However, because Company 2’s EBITDA grew at 68% vs Company 1’s 12%, Company 2’s ROI was 110% and Company 2’s ROI was 12%

• The person who acquired Company 2 walks away with an additional $3.9M more than the person who acquired Company 1

	Company 1	Company 2
EBITDA	$1,000,000	$1,000,000
Multiple	4.0x	4.0x
Acquisition Cost	$4,000,000	$4,000,000
Year 5 EBITDA	$1,121,670	$1,680,236
Year 5 Multiple	4.0x	5.0x
Year 5 Valuation	$4,486,680	$8,401,181
ROI	12%	110%
Valuation Gain	$486,680	$4,401,181

As you can see, performing sound Operational Diligence is about ensuring you are acquiring a business that can protect your debt obligation and allowing you to be in the driver seat on day 1, so you are focused on growth rather than hidden surprises.

What is Reviewed During Operational Diligence

Business Review:

Operating & Board Meeting Reviews, Board Member Bios, Strategy Implementation and ROI

Risk Review: Key Man and Concentration Risks:

The Key Review is not just about the owner, but also includes Key Salesmen, and People Who Hold Exclusive Technical Knowledge. Concentration Risks Including Client, Vendor, Sales Channel, and Product Categories. Other Risks Reviewed are Market and Competition.

Marketing & Sales Review:

Customer Acquisition Processes, Account Management, Customer Acquisition Cost (CAC), How Customers are Moved Through the Funnel, Retention, Lifetime Value (LTV) Brand, Return on Ad Spend (ROAS), Revenue Modeling, Social Media, and PR

Financial Review:

Budgeting, Forecasting, P&L, Cash Flow, Tax, Financial Planning and Analytics (FP&A), General Ledger, and Close Processes

Supply Chain & Operations Review:

Process Review, Vendor analysis, CapEx review (if required), Productivity, Yield, logistics, Risk Mitigation, Sales & Operations Planning (S&OP), Inventory Analysis

Technology Review:

Vendor analysis, Tech Stack (Ops & Supply Chain, Finance, Sales & Marketing, HR, Data, Commerce, & Website), Hardware, CapEx (if required), Cybersecurity

Data & KPI Review:

Review of How Key Metrics and How Company Uses Metrics

Customer Service:

Customer Journey, Inbound Calls & Email Error rates,

Team & Human Resources Review:

Company Culture, HR Policies, Compensation & Benefits, Organizational Chart, Talent Assessment, Gaps, L&D

Beyond Operational Due Diligence & Next Steps

Beyond the Operational Due Diligence report, the firm you work with should provide a post-acquisition strategy and integration. Even if you are a seasoned owner, operator, or industry expert, a third-party review is always important to ensure thesis validation, blind spots are not missed, and areas of opportunities are generated. For example, what are the areas for growth, quick wins, how should you think about team, are there customer service opportunities, budget & pro-forma recommendations, etc…

Additionally, the firm you work with should, if requested, provide a 30-60-90 day implementation plan. The implementation plan is especially helpful for first time Acquirers who are likely to be disoriented post-acquisition. The 30-60-90 should not just be a checklist, but tangible recommendations that are customized to your business.

Lastly, the firm who completes your Operational Diligence, should have the capability of offering Fractional CXO services. For example, CEO, COO, CMO, CRO, and CFO Services. During transitional phases, especially in the lower-middle market, there may not be team members who have been in a CXO position. A knee jerk reaction could be promoting a team member as your new GM or COO because they know the business better than you. While you may see short term gains, it may be hard to dislodge a newly minted GM and they may have not scaled businesses before. At a minimum, a Fractional CXO should help to ensure financials have been transitioned, both the budget and operating metrics have been set, customer pipeline has been established, and several rounds of Operating Reviews have been completed.