Three critical questions rarely addressed in the diligence process

Having been on been on both sides of the fence through multiple due diligence processes (i.e. both a buyer and a seller), I can state with confidence that more often than not, far too much time is allocated to redundant financial analyses and far too little time is dedicated to getting answers to a handful of questions that ultimately define the success or failure of the investment and/or acquisition. The reality is that 95% of what needs to be known about a company's current financial capacity is uncovered within the opening forays of the diligence process, regardless of whether that diligence was done by an individual investor or a small army of analysts employed by a private equity firm.

This is not to say that capable financial analysis is not a fundamental component of an effective evaluation because it definitively is. An investment opportunity that cannot at the very least illustrate a healthy return on paper need not be considered any further. I would suggest, however, that if more time and resources were focused on the "not-so-obvious" factors influencing a company's future performance and capacity, there would be a significant increase in successful corporate investments. While there are a number of these not-so-obvious elements to consider, our experience has been that the following three questions usually solidify a prospective company in the hit or miss category:

1. What is the sustainability of the opportunity pipeline? - Most company's can paint a pretty picture that is represented by a snapshot in time. The true measure of a company's medium and long-term capacity will be uncovered once you have assessed its ability to generate and replicate an opportunity pipeline that will generate the type of annuity that aligns with your valuation.
2. How capable are the critical members of the management team? - While biographies will provide you with an elementary history of the individuals running the company, nothing can or should supplant comprehensive interviews that will allow you to form your own assessment of whether or not the existing team is capable of delivering the results on which you are depending.
3. What role, if any, do external parties play in defining the company's direction? - A Board of Directors, a Board of Advisors or a significant shareholder can all exert tremendous influence on a company's management team. It is imperative that you gain some reasonable insight as to the likelihood that a third party may alter the strategic direction of your new investment.

Interest will often be piqued when a company's financials align with your investment metrics. However, positive answers to these questions should provide you with the confidence that your investment will actually deliver on these metrics weeks and months after the diligence process is complete.