In this series of articles, I will post ten simple ideas from chapters in The Ernst & Young Business Plan Guide (3rd edition). This fourth post in the series brings out ten simple ideas from Chapter 4, Due Dilligence.
Introduction
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Post four in this series offers ten simple ideas from chapter 4 in The Ernst & Young Business Plan Guide (3rd edition), Due Dilligence. In a phrase, the point of the chapter is described in the sub-title, Think like the Pros.
The chapter tells us that up until the 1990s, business would create a "book" describing the business that was for sale. Potential investors would be responsible to review the book to see how the asset fit with their own plans, and to identify risks - a process known as due dilligence. More recently, a concept named reverse due dilligence has emerged in order to protect a business from having multiple investors and competitors combing through its books.
The following discussion will cover ten simple ideas about this process that come from the chapter.
Ten Simple Ideas from chapter 4 - Due diligence
1.) Due diligence is all about identifying risks.
People tend to think of due diligence as a search for fraud or misrepresentations. In practice, that is a very small portion of the risk that is identified. The more routine type of discrepancy that is more frequently found is described in the example of an offer book that describes a company's "excellent customer service" without disclosing that a key customer service executive is not transitioning as part of the sale.
2.) Four types of risk are identified, including financial, operational, business, and transaction risk.
Financial risk includes things like market, credit, and liquidity risk along with fraud, tax, and exit strategies.
Operational risk includes product risks, distribution channels, information security, and business continuity. Product risk can be further broken down into raw materials, design/engineering, supply chain, manufacturing operations, and compliance with legal or regulatory standards.
Business risks include technology disruption, changing competition, intellectual property, governance and human resource risks, CEO succession, employee relations, business conduct and ethics compliance, and environmental concerns.
Transaction risk includes the deal structure, tax and accounting considerations, and comparable valuations of competitors and industry leaders.
3.) Start-up entrepreneurs should pay careful attention to transaction risks.
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When launching a business, you are especially vulnerable to transaction risk because your business is financially vulnerable and hasn't yet established its reputation. Failed transactions mar the reputation of any business, but they are especially damaging and frequently fatal for start-ups.
4.) The entire transaction life-cycle is subject to risk. This life cycle includes: strategic analysis, opportunity analysis, transaction development, negotiation & execution, and transaction effectiveness.
There is not much to add to this, but it is important to recognize that from initiating a transaction until completing it, the corporate risk profile is undergoing constant adjustment.
5.) In recent decades, responding to inter-dependencies, transaction risk analysis shifted from micro-level to macro-level.
In the past, transaction risk has been considered at the micro level and evaluated by appropriate departments or experts. This includes discrete areas like legal, human capital, regulatory aspects, and others. More recently risk is being evaluated at the macro level because of the inter-dependencies that arise in complex deals.
6.) Common transaction failures arise from inadequate risk assessment.
The chapter lists some specific forms of risk assessment failures, including the following: pursuing the wrong deal, paying too much for a business or asset, price/margin erosion, overstated revenue and cost synergies, market shortfall, and poor integration or implementation.
From the business plan perspective, the entrepreneur needs to include information in the business plan to help the purchaser navigate these potential risks.
7.) The authors suggest using a "transaction scorecard" to evaluate risk.
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This scorecard covers metrics in at least four categories: financial, business processes, markets, and human capital. Other metrics may also be included from categories such as legal, regulatory, environmental, or public image.
Therefore, the business plan should include information to fully develop relevant metrics in the above mentioned categories.
8.) No matter how much due diligence is performed, it is usually impossible to identify all potential risk factors.
This is true of all mergers and acquisitions, but it is especially true of start-ups where everything is still theoretical. In transactions with mature businesses, there is real world data to back assumptions, but in a start-up the chapter notes that many assumptions are made by the "seat of the pants."
9.) If a risk is discovered after an agreement is reached, it may still be possible to adjust the purchase price.
A prominent example of this from business news in recent years was Verizon's acquisition of Yahoo. After the deal had been struck, Yahoo announced that they had been victims of a security breach. As a result, the sale price was reduced by $350 million.
As an entrepreneur, you definitely don't want to find yourself in this situation, so you should make sure that potential buyers are as informed as possible.
10.) Your business plan should include everything "you would want to know if you were going to invest."
This chapter was written from the perspective that due diligence from normal business acquisitions can provide guidance to the entrepreneur who's seeking funding for a start-up. Remembering back to chapter 2, that one of the "four Cs" that lenders look for is "Character", and that venture funds look for maturity and experience, it is critical that the entrepreneur demonstrate these characteristics by providing a robust and complete business plan that answers as many of their questions as possible.
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Conclusion
One key idea from this chapter is that the business plan should demonstrate a form of reverse due diligence. As the subtitle noted, the business plan should demonstrate that the entrepreneur is thinking like the pros. A second key idea is that the business plan should include everything that the entrepreneur would want to see if the roles were reversed.
Check back soon for reviews from Part 2 of the book, An In-Depth Look at a Business Plan. The next post will cover, Chapter 5 - Contents, Chapter 6 - The Executive Summary, and Chapter 7 - General Company Description.
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Previous Articles in the series
- [Ten Simple Ideas] The Ernst & Young Business Plan Guide: Chapter by Chapter - Series Overview and Chapter 1
- [Ten Simple Ideas] The Ernst & Young Business Plan Guide: Chapter by Chapter - Chapter 2 - Who Reads the Business Plan?
- [Ten Simple Ideas] The Ernst & Young Business Plan Guide: Chapter by Chapter - Chapter 3 - Legal forms of a business
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Steve Palmer is an IT professional with three decades of professional experience in data communications and information systems. He holds a bachelor's degree in mathematics, a master's degree in computer science, and a master's degree in information systems and technology management. He has been awarded 3 US patents.
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