The private equity investment process
Stage: Due dilligence
Entrepreneur + VC: Liaise with accountant
Liaise with other external consultants
VC: Initiate external due diligence
Reports: Consultants report and Accountants report
Due Diligence
- Verification process to provide assurance that all the assumptions on which an investment or acquisition decision are based are true
- Not just “box-ticking”, but a value-adding approach
- Can also identify areas for improvement and risk reduction, leading to potential additional gains
- Contributes to understanding of markets and strategic opportunities
- Investors, advisers, management team need to work openly together throughout due diligence process.
VCs pre-conceived ideas on a firm:
Product / service commercially viable?
Potential for sustained growth?
Management’s ability to exploit potential?
Management’s ability to control through the growth stages?
Does the possible reward justify the undoubted risk?
Does financial return on investment meet investment criteria?
+ Porter’s 5 Forces
Types of due diligence
- Commercial
- Financial
- Management
- Operational
- Legal and regulatory
- Technology / product
- Environmental
- Forensic
- Other (pensions, insurance, antitrust, political)
Due diligence process
- Set Issues and Objectives
- Select Advisers
- Briefing, Timetable
- Management Liaison
Commercial due diligence
Credibility of revenue projections and assessment of market prospects:
- Customers and competitors
- Existing and projected market share
- Is market expanding?
- Product’s (or service’s) unique selling point (USP), ie its competitive advantage over other, similar products
- Reaching overseas markets
- Testing / evaluating key strategic drivers in business plan
Brand due diligence: strength and valuation of brand and intangible assets
Patentability and ownership of intellectual property
Financial due diligence
Independent review of:
Historic financial performance
Latest available management accounts
Management information, financial reporting and internal control systems
Forecasting techniques and accuracy of past forecasting
Financial projections and assumptions
Working capital and cashflow
Bank facilities and covenants; leasing arrangements
Tax compliance
Post-transaction funding position
Comparison of projected financial performance with available facilities
Management due diligence
Subjective views of investor
Detailed review of CVs
Taking references
Informal feedback from advisers
Use of psychometric specialists – team compatibility, managing a PE backed company
Management structure
Succession issues
Forensic (management’s track record, reputation, integrity, reliability)
Operational due diligence
Covers: manufacturing and production process, supply chain, outsourcing
- Identify weaknesses
- Scope for improvements
- Depth of management
- Additional resources required?
Also due diligence on company’s IT system
Reliance on parent for infrastructure and operations > separation and stand-alone post MBO
Legal and regulatory due diligence
- Regulatory environment
- Compliance with regulatory requirements
- Major commercial contracts
- Litigation – status of and likely outcome
- Potential for future litigation
- Title / ownership of assets
- Patents and IP protection
- GDPR and data security
- Employment contracts and issues (disputes, tribunals)
Technology due diligence
The technology itself:
- Is the technology proven, supported by a commercial prototype, with protected IP?
- Is it a “disruptive” technology?
- How long is the technological advantage likely to be maintained?
- Competitive advantage – or a “better mousetrap”?
- Proven market demand? Do people want it?
- Production needs / reliability?
Other aspects:
- Software development environment
- Security framework, including cyber security
- Data management
- Business continuity / Disaster recovery
- Digital due diligence (eg customer/ market trends from internet)
- Use of AI in due diligence processes: faster, more accurate, more insightful
Environmental due diligence
- Compliance with environmental regulations
- Land contamination
- Hazardous materials
- Environmental management
- ESG: environmental, social, governance
Other due diligence
- Pension liabilities, obligations, funding
- Insurance coverage and premiums
- Antitrust and competition laws
Covid-19 implications - Social impact and purpose, ESG (environmental, social and governance)
- Reputational risk
- Political (geopolitics, regulation, policy uncertainty, trade conflicts, security concerns)
Also, vendor due diligence
Actions following due diligence
If due diligence is satisfactory:
Proceed with deal
Rewrite business plan to take account of all findings from due diligence process
This will become the guide for the business moving forward.
If due diligence reveals issues:
Correct the issue if possible
Re-negotiate terms of the deal
Abort the deal, if major problem.
Legal agreements
- Shareholders’ (subscription) agreement – terms of investment, continuing obligations of management
- Memo & Articles – company constitution / relations between shareholders and directors
- Investors’ rights agreement – rights of the VC with regards to the investment
- Warranties – confirm specific information provided by directors/existing shareholders
- Indemnities – reimbursement of agreed amounts by directors/existing shareholders
- Bank loan agreements
- Service contracts – for key members of management team
- Disclosure letter – key information disclosed to venture capitalist (limits warranties and indemnities)
