Resource to ensure the proper operational due diligence is being performed when conducting M&A activities. Great source for questions to ask across all areas.
Contents:
- THE DUE DILIGENCE PROCESS
- PLANNING FOR DISCOVERY PHASE
- ON-SITE ASSESSMENT PHASE
- ASSESSMENT REPORTS PHASE
- CUSTOMER SATISFACTION
- PRODUCTION
- INFORMATION MANAGEMENT
- SALES & MARKETING
- ORGANIZATION
- PERSONNEL
- FINANCIAL
- LEGAL
- INSTITUTION
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My Notes
The businesses worth investing in are the sustainable businesses that are revenue based, product driven, and supported by an infrastructure that has been designed to sustain the business's long-term growth.
Risks that are not mitigated today become problems that need to be resolved tomorrow.
Due Diligence: a process for searching beyond the products and venturing, by analysis and assessment, through three distinct facets of the business - its financial, legal, and operations frameworks - to discover clues for predicting its long-term sustainability.
The goal of financial due diligence is to establish a true current valuation for the business. For instance, it might indicate that the business had exceeded its sales goals for the last two years.
Operations due diligence includes an assessment of the financial infrastructure and continuing financial operations of the business.
The goal of legal due diligence is to explore the current legal status of the business, including any outstanding issues of ownership, pending legal actions, outstanding judgements, liabilities, employee actions, insurance claims, intellectual property (IP) rights, government limitations, certifications, and professional licenses.
Operations due diligence for legal includes an assessment of the legal infrastructure and continuing legal operations of the business.
Some businesses design their operations infrastructure in great detail, but others let their infrastructure evolve almost as an afterthought as the business grows and new needs arise. The latter is often called organic growth.
The goal of Operations Due Diligence is to allow an investor to determine the maturity of the business's operations infrastructure. Operations Due Diligence assesses the entire organization to determine how efficiently and effectively the business operates and to identify opportunities for improvement.
Managers who run their business as if it is always for sale are constantly trying to maximize its value for investors. By assessing their own operations, managers are able to identify areas with latent risks and opportunities, and they can use this information to prioritize limited resources to target their process improvement needs. If managers perform internal assessments on a periodic basis, they will be able to use the results as a benchmark to measure their progress over time. Managers concerned about their jobs can use this as evidence of their personal performance and also to defend the expense of a self-assessment in their next budget.
Operations Due Diligence may be conducted more efficiently and honestly if it is contracted to an independent, external consulting team.
Operations Due Diligence should not be looked at as a test that has a passing grade. The correct answers depend on achieving a balance between the risk the investor is willing to take and the opportunities the business offers.
Look out for the "I believe" and "I expect" statement in any form. Whenever you hear this, a bell should go off in your head to ask more questions. Your job is to find out what the facts really are, not what someone "believes" they are. That is, unless of course you are relying on their expert opinion.
"We have a policies and procedures manual. We follow defined processes and have an active process improvement group." Yes, you have a policies and procedures manual, but do your employees have a copy of it, and have they been trained in the procedures, and is there an ongoing effort to improve on the procedures that the employees participate in? The BS Quotient is much higher in the first statement.
One way to help this along is to respond to answers by asking a simple question: "Can you show me evidence of that?"
THE DUE DILIGENCE PROCESS
Defined in 3 phases:
- Planning for Discovery Phase
- On-Site Assessment Phase
- Assessment Report Phase.
PLANNING FOR DISCOVERY PHASE
Designed to give you early insight into the business and its markets. Your strategy should be to plan greater disclosure in the areas you foresee the greatest risks or opportunities.
Your plan needs to identify any specialized skills needed by the assessment team. Will you need to look at software source code or other areas requiring engineering specialization? If so, people who have these skills need to be identified and included as members of the assessment team, and they need to be trained how to perform a due diligence.
Nondisclosure agreements need to be signed.
ON-SITE ASSESSMENT PHASE
You will have provided the agenda to the business in advance of the on-site assessment, and you will have established a single point of contact that you will be able to work through. The business will need to collect any requested documentation in advance, along with any records or other data requested.
Your assessment shouldn't be limited to an existing due diligence file, and you should feel free to make any requests you deem necessary. It's your job to lead the assessment, and this is your event, so request any additional data you feel you need, and don't rely strictly on the view of the business that its managers want you to see.
ASSESSMENT REPORTS PHASE
Using a format that will support an eventual investment decision, the assessment results will need to be described in the form of potential risks that need to be mitigated and opportunities that can be captured (e.g., SWOT analysis).
The responses to some questions may leave room for more subjectivity. I use a very simple response method intended to be self-evident to a reviewer and provide an easy ranking:
- Don't know
- Weak area
- Work in progress
- Strong area
- N/A
- Comment
This type of response to subjective questions is preferred beacuse it records your observations rather than requiring a numerical score to quantify the results, and it supports the categorization of the data rather than appearing like qualitative test answers.
CUSTOMER SATISFACTION
- Does the businesse measure its level of customer satisfaction periodically?
- Does the business plan rely on high levels of customer satisfaction to drive recurring sales?
- Does the business publish customer satisfaction guidelines defining how employees will interact with customers?
- Who is responsible for managing customer satisfaction?
- Is customer satisfaction a competitive discriminator for the business?
- Which of the three customer satisfaction discriminators (cost, reliability, and usability) does the business have a reputation for leading in?
- What are the customers' perceived life cycle cost and ROI for the use of the business's products?
- Has the business established a reputation for reliability with its customers?
- Does the business identify and collect customer satisfaction metrics throughout the life cycle of the product?
- Does the business measure product support response time as an element of customer satisfaction?
- Does the business offer product support and product training that are compatible with the complexity of the product?
- Who is responsible for prioritizing which product requirements will make it into production?
- Does the business operate a cross-functional change control board?
- Is the business using evolutionary development methods such as Agile development? If so, how is the scope of projects being managed?
- Does the business perform customer acceptance and validation testing?
- Does the business maintain product test logs that list open and closed test issues?
- Do any previously shipped products have known problems for which the business may be liable?
- Are complexity metrics collected to determine the reliability of software products?
- Is the product a "first release," or is it an upgrade to a previously shipped product (and therefore it has been tested through wide customer use)?
- Does the business offer fee-based product training?
Documents Needed:
- A list of all pending or suspected customer claims based on known product defects
PRODUCTION
- Is the product continuing to evolve, or has its development become stagnant?
- Are all license agreements with third-party suppliers assignable to the investor if needed?
- Are all royalty payments to third-party vendors current and up to date?
Documents Needed:
- All royalty agreements
- All vendor or reseller agreements
INFORMATION MANAGEMENT
- Is there an information management system design document that describes the entire system, and is this document kept current?
- Is there an integrated database that supports all activities across the business?
- Has the business standardized its operating systems, software applications, and/or hardware platforms?
- What procedural, physical, and logical security protections does the business use to guard its information management system?
- Has the budget accounted for the development and production tool costs and/or the software development environment tool costs?
Documents Needed:
- Software development life cycle process descriptions
- Engineering design documents and product artifacts
- Hardware test plans for all products
- Software test plans for all products
- Test bug or deficiency logs
- Risk management plan and/or process and current data
SALES & MARKETING
- Are there sales and marketing process improvements that would increase the opportunities for product sales?
- Is there a coordinated sales and marketing strategy that spans the business?
- Does the business conduct periodic state-of-the-business discussions with the employees to explain how the business is doing with its sales?
- Has the business established a recognizable brand image in the market?
- Does the business have a sufficient marketing budget?
- Does the business use a contact management system?
Watch the BS Quotient when discussing the business's market position; in particular, listen for the "I [or we] feel" statement. "We feel we will be able to completely capture this market segment." "Oh really, based on what?"
- What is the public persona of the business? Is the actual perception of the market consistent with the persona that marketing is trying to create?
- Has the business conducted a recent competitive analysis?
- How does the business establish a strategic plan for its products, and how well does it follow this plan?
- Does the business follow a strategic plan that guides its future direction in the market?
- How well does the strategic direction of the business align with the direction of the market?
- How frequently does the business change its strategic plan?
- Does the business have a formalized process for collecting customer feedback as part of its product management?
- Does the business follow a defined sales process?
- How does the business monitor and measure its sales pipeline results?
- Are the sales projections based on the closure of sales to specific customers, or do they reflect an effective long-term strategy?
- Are there any plans to change sales territories?
- How does the business manage its sales territories and allocate the sales representatives' rights to mine these territories?
- What type of training and support does the business provide for its channel partners?
Documents Needed:
- Sales process
- Marketing plan
- Strategic plan
- Current sales pipeline and lead trend charts
- List of current customers including contact information for key customers
- Customer training plan
- Current and past customer lists
ORGANIZATION
Three layers of organizational infrastructure:
- Legal structure (corporation, partnership, C corporation, S corporation, etc.).
- Command and control structure (its organization chart).
- Corporate culture (working environment and public persona).
- Has the structure of the business been optimized according to its planned growth, or does it reflect organic growth?
- Does the business hae a published organization chart, and are the employees aware of it?
- Does the structure of the business support the use of repeatable processes, or is each new project a one-of-a-kind solution?
- Are the roles of each person in the organization clearly understood?
- Does each employee have a writtend job description?
- Does the business have a hierarchical or a person-centric commend and control structure?
- How many direct reports are controlled by each manager?
- Is there a dotted-line organization in place that encourages working outside the published organizational structure? If so, why is this necessary?
- Who are the members of the management team?
- Is there a management team skills matrix?
- What is the corporate culture of the business and how does it fit with our company?
- Do the values of the management team align with those of the investor?
- Are the workflow and processes of the business based on any unique intellectual property?
In castle cultures, the employees in each group or department perform their own function and are responsible solely for the success of their own group. The scope of the group is limited to the responsibilities of their own immediate organization.
- Are there any signs of castle culture behavior among the employees?
- Does the business have a published ethics policy, and is each employee required to sign it?
Documents Needed:
- Ethics policy
- Organization chart
- Oganization mission statements
- Job descriptions
PERSONNEL
- What is the longevity and average turnover rate of employees?
- How does the business proactively monitor changing regulations that could impact its legal, financial, and operations infrastructure?
- Does the business publish a list of employee benefits?
- What fringe benefits does the business offer its employees?
- Does the business conduct an annual benefits review and planning session?
- Is the annual growth in employee compensation planned, and has it been budgeted?
- What compensation packages do employees currently receive including both salary and benefits?
You will need to request a list by element (salary, bonus, options, and so on) of any compensation provided for each employee for the last three years and a list of all scheduled or promised future compensation.
- Does the business analyze the competitive salary range for each position or conduct a periodic review of the cost of benefits to ensure that its compensation rates are competitive? How does the business establish the salary and benefit guidelines for next year?
- Are there any existing agreements with organized labor? Are there any known or ongoing actions to organize employees within the business?
- Are there established processes for hiring and terminating employees?
- Are personnel actions and discussions documented in the employee personnel files?
- Are there any outstanding employee sign-on incentives? If so, what is their value, and when do they mature?
- Is there an established process for conducting employee performance appraisals?
- Are performance appraisals tied to increases in salary and/or bonuses, and how has the business planned for these increases?
- Does the business have performance appraisals for each employee for the preceeding three years?
- Does the business have a published promotion policy?
- Is there a management team review of exit interview comments?
- Is there an established process for conducting a termination for cause, and are managers trained in executing this process?
- Is there a list of all employees who are currently on performance notices?
- Has the business had any labor reductions or terminations without cause? If so, when were they, and how many employees were involved?
- What outstanding termination agreements does the business have?
- Have there been any formal or informal termination agreements made with existing employees?
- Is the value of the business limited to the strength of the employee resumes?
- Does the business have the right people doing the right jobs?
- Are some people doing jobs that could be accomplished by other people in lower pay grades?
- Does the business maintain a skills database?
- Are there any identified employee workflow bottlenecks?
- What has been done to protect the business against the loss of key employees?
- What incentive programs are in place to motivate employees to go above and beyond to help the business succeed?
- Does the business have a management goal setting policy?
- Does the business have an employee retention plan?
- Does the staffing curve correlate with downturns in the profitability of the business?
- What employee training is required, and does the business have an annual training plan?
- Are employee training expenses included as budget items for all groups?
- Does the business measure its training effectiveness?
Documents Needed:
- Performance appraisals for each employee for proceeding three years
- A management team skills matrix and a management team skills arachnid
- A list of all of the employee benefits offered by the business
- A list of all full-time, part-time, and contract employees currently employed by the business or employed by the business within the past three years
- The personnel file for all employees
- The performance appraisals for each employee for the proceeding three years
- A list of all employees who are currently on performance notices
- A copy of each empolyee's resume or CV
- A copy of all employment contracts
- A staffing curve showing staff loading over time and explanaitons for any downturns in relation to the profitablitiy of the business at the time
- A list of element (salary, bonus, options, and so on) of compensation for each employee for the last three years and a list of all scheduled or promised future compensation
- Employee training plan
- Compensation plan
FINANCIAL
- Does each manager have a defined and documented level of financial signature authority?
- Does the business need to comply with the Sarbanes-Oxley Act, or does it anticipate a future compliance requirement?
Sarbanes-Oxley will have a cost impact on privately owned businesses if they plan on going public in the future, and investors must be aware of this impact.
- Has the accuracy of the business's financial reports been validated?
- Do the prior tax returns support the business's income and expense claims?
- Do all group managers review their P&L reports on a periodic basis?
- Do the revenue, expense, or earnings trends reflected in the P&L reports indicate any operational risks or opportunities?
- Does the balance sheet identify any operational risks or opportunities for the business?
- Have the cash reserves dwindled over time?
- Has the business established a track record for timely collection of its accounts receivable? Has the business established a track record for meeting its account payable obligations on time?
- Has the business failed to make any of its past payroll expenses in a timely manner?
- Are revenue projections available for at least the next three years?
- A pro forma projection is an esitmate of the value of future sales.
- How much detail is behind the business's pro forma projections?
- Does the business track the time-to-market for each product line?
- If the projections show hockey stick growth, is there a rationale to support this increase, and is there an equivalent ramp-up in the operations expenses of the business?
- Is the business reporting all sales and all operating expenses, or is it making pro forma adjustments?
- Are budgets created at ech operational level of the organization?
- Do functional managers own their budgets or does finance create their budgets for them?
- Is financial authority delegated to all managers to execute their operations plan according to their approved budget?
- How are budget performance goals established?
- Is there a mechanism for modifying the budget in response to the changing operational needs of the business?
- Does the business hold a management reserve?
- What level of control do program or project managers have over budget and schedule?
- Does the business separate the roles of functional managers and program or project managers?
- Do the program or project managers have responsibility for profits?
- Does the business use a cost account management system (CAM) to track true project costs?
- Does the business track and allocate material and contract costs to each project as they are incurred?
- What performance metrics does the business regularly collect and track?
The difference between budgeted expense and an actual expenes is the cost variance, and the difference between projected revenue and actual revenue is the revenue variance.
- What do the budget variances indicate about the performance of the business?
- Does the business hold periodic operations reviews including the preparation of periodic operations reports?
- Are managers held accountable for budget and schedule variances, and do they provide a rationale for significant performance deviations?
Loaded labor rate includes the employee base salary plus overhead expenses that are allocated to it on a per employee, per hour basis.
- Does the business track its loaded labor rates? Can the business provide a breakdown of its loaded labor rates?
- What is the history of warranty payments or reimbursements for product guarantees?
- Have all scheduled cost increases been identified and disclosed?
- Is the employee option plan accounted for within the growth provisions of the business, and will the employee-owned stocks cause stock dilution? How many outstanding employee options are there, and under what terms were they issued (e.g., term, value, or vesting)?
- What lines of credit does the business have, and what is the history of its use of those funds?
Documents Needed:
- Profit and loss statement
- Balance sheet
- Pro forma projections
- Cash flow statement
- Capital investment and depreciation schedule
- Policy on financial authority
- Copies of the business's tax returns for the last five years
- Pro forma revenue projections for at least the next three years
- A breakdown of the loaded labor rates
LEGAL
- Does the business have documented policise and procedures that guide its legal operations?
- Does the business review its legal policies and procedures on at least an annual basis?
- How does the business manage its legal agreements and binding documents?
- Does the business have standard templates for recurring documents, and have those templates had a complete legal review?
- Does the business allow some level of management sign-off on binding documents without review by an attorney?
- Does the business make a distinction between financial signature authority and legal signature authority?
- How does the business delegate legal signature authority?
- Does the business have a contracts group?
- Does the business have all of the professional licenses it requires?
- How does the business review and monitor the rules and regulations that govern its operations?
- Does the business employ specialists, such as financial market consultants, to help it comply with complex and/or changing regulations?
- What intellectual property has the business identified and captured in the form of patents, trademarks, or copyrights?
- Are emplyees trained to recognize and identify intellectual property?
- Is the exsiting intellectual property protection sufficient to protect the proprietary assets of the business?
- Does the business have any potential intellectual property infringements?
- Does the business have sufficient insurance coverage, and does it review its coverage on an annual basis?
- What outstanding insurance claims are there, and what claims has the business filed in the past?
- Does the business have a document retention policy, and is there evidence that the policy is being enforced?
- What personal data does the business possess that is covered by privacy rules and/or regulations? Is the business aware of all privacy regulations that apply to its operational data?
- What steps has the business taken to protect and monitor access to its employee, customer, and third-party privacy data?
Documents Needed:
- All contracts
- All insurance policies
- All present, prior, pending, or potential litigation
- All strategic agreements
- All nondisclosure agreements
- All employment and labor agreements
- Legal authority policy
- Document retention policy
- Data privacy policy
- Network usage policy
- A copy of all standard document templates, with those identified that have been through a legal review
- A list of the captured intellectual property and copies of all existing patents, copyrights, and trademarks
- A list of all assets the business considers proprietary that have not been captured as intellectual property
INSTITUTION
- Does the business operate in an ad hoc manner, or does it operate in a determined, focused manner that it constantly seeks to improve?
- Does the business routinely document its operational policices and procedures, and is there evidence that employees are following them?
- Is the business certified in the process methodology for the primary market it serves?
- Does the business collect process data to support its future cost and schedule estimates?
- Is the cost to maintain the institutionalized processes included in the budget? Does the business monitor product improvement trends, such as reduced defect rates, to justify the ROI for its process improvement program?
- Does the business recognize the connection between managing its processes, quality assurance, customer satisfaction, and improved sales, and has it established goals in these performance areas?
- Does the business have a process improvement group that meets on a periodic basis? Does the business create an annual process improvement plan?
- Is there a list of the existing documented processes, supporting forms or other data, and evidence that the process is being followed across the entire business?
- Does the business maintain rigid development standards and defined levels of tolerance for the performance of its products?
Documents Needed:
- All existing documented processes and historic evidence that they have been followed
