S1-E5 | Phase 4: Due Diligence — Managing Complexity

Transcript

SPEAKER_00 0:02

Hi everyone, I'm Joshua Johani, your host here on our podcast, The Technical Founder, Advanced Topics in MA and Investment Banking. I'm here with our co-host, Ricardo Overlander. How are you today, Ricardo?

SPEAKER_01 0:16

I'm extremely well. How are you doing, Joshua?

SPEAKER_00 0:19

That's great. I am doing well, also. I'm excited to talk about episode five, which we're calling Due Diligence Managing Complexity with Clarity. So this comes just after our IOI to L Oi section. This moment in the investment banking process typically involves exclusivity with a single buyer. And this is the moment where the buyer goes in to confirm or not the assumptions that they've made and putting together the economic offer that goes in front of the seller. Ricardo and I are going to talk about a number of things before we get to our key takeaways. But I think that one of the things we're going to focus on in this decision and inflection point within the deal is really how buyers actually make decisions and how a superior buyer indicates their ability to make decisions is a lot more decisive. They're just a lot more confident in what they are or they are not looking for. And the next episode after this one is where we get to the purchase agreement, which is where the rubber meets the road. Ricardo, when you look at due diligence and the complexity that comes from that and the ability to drive clarity, what are things that technical founders, because you know, we're talking mostly to an audience of scientists, engineers, or extremely high-caliber marketers, people that have really deep domain expertise that is got to be more advanced than the folks doing the diligence, the big four consulting firm, the QOE firm. So when a seller or a buyer goes into this process and they want to communicate this complexity, what is the advice you would give them to consider?

SPEAKER_01 1:59

Joshua, you mentioned a verb which actually we could summarize the essence of due diligence. You mentioned confirm. Because due diligence is where everything that has been said and everything that's been assumed is tested. Due diligence is not about discovering perfection, it's about confirming credibility. And most people think that due diligence is about verifying numbers, and that's the surface. At a deeper level, due diligence is testing three things. First, consistency. Do the numbers match the narrative? Second, transparency. Are the issues disclosed early or discovered late? Third, predictability. Can this business perform reliably going forward? Buyers are just not just validating history, they're assessing whether they can trust the future. And trust is built or broken here at this phase.

SPEAKER_00 3:04

When you think about the confirmation that a buyer is engaging with the seller, they're confirming the information that largely the investment banker has provided them with prior to engaging in this exclusivity. And we talked about this quite a bit in the IOI and the LOI sections is that you want to give information. Accuracy is absolutely paramount, but you don't want to give too much information. And one of the areas where we work very hard at Jahani is to understand how buyers are really going to make these decisions and to make sure that we are giving them information that they need to make material decisions before they get to due diligence. Because if you withhold that information as an investment banker, it can actually lead to a major loss of momentum and just a slowing down of the process when buyers have to go in. And for example, if they have to do all their technology diligence, all their demo diligence, and loop in all the technology folks during the due diligence period, I mean, that alone is going to take several weeks. And you're trying to do that at the same time as financial, accounting, uh legal, and other kinds of more blocking and tackling due diligence. It can really derail everything. Have you had experience with that kind of commercial diligence that went positively or negatively, Ricardo?

SPEAKER_01 4:27

Yes, I have, Joshua. And I think you're illustrating the responsibility that an investment bank, a serious investment bank, has to demonstrate during this phase. Because at the end of the day, a buyer is relying on the efficiency and effectiveness of the investment bank in order to check whether not only the numbers are correct, but also whether they are understood. Buyers look for revenue quality, margin stability, cash flow predictability, working capital behavior. I mean, substance behind the job and executed by the company. Quality of talent that's often neglected. And at the end of the day, when a company when a company is acquired by another one, I mean, it comes with people, it comes with managers, it comes with different employees and different key roles, which actually need to keep the company running. I mean, the technological status of the company is often that so, because that actually is critical, especially in the pace of development that we have nowadays in the technology space. Also, the legal issues, the compliance issues, the pending legal cases, for instance, or lawsuits, all that actually composes a picture that the investment banker, especially under the responsibility that he or she has to carry, needs to demonstrate to the buyer.

SPEAKER_00 6:07

We talked about in our episode two and specifically our preparation phase. We talked about how and when to use advisors. And I've got a couple of questions for you that our clients actually ask us all the time. Is there's sort of an underlying assumption that I have used when I talk about, you know, moving from pre-bidding and bidding and into diligence. The underlying assumption is that the way that the sell side business is operating is completely void of issues. And, you know, sometimes small businesses are genuinely easier from an accounting perspective. But we've had many clients that are not large, they're medium-sized, they'd be, you know, 50 to 200 million in revenue, that, you know, have physical assets that perhaps they do some kind of value-added service to and then might resell. These are things like sensors, IoT devices. Um, and a lot of times they may be doing their accounting incorrectly. Uh that sort of accounting validation is not in the scope of the investment banker during the preparation phase, and there's an assumption that all that is done correctly. So if you have a seller, how would you advise them, or how would you think about this as the transactions you've gone through, Ricardo, to think about when to engage in what I'll call highly structured preparation? And what that means is doing a sell-side quality of earnings, doing a sell-side audit, things like that that are sort of outside the normal business model and would be a distraction for companies of middle market size. Um, how how would you advise them to think about that to avoid any kind of just incorrect financial showcase during the diligence process?

SPEAKER_01 7:51

I think this is a critical question because for any business involved in a transaction like that, especially the buyer side, it's critical to avoid paralysis by analysis. Because there are so many different issues that we could actually list in in this area. Because we mentioned about the financial areas, but that's about there are legal and structural issues where surprises in general can be disproportionately damaging. Operational issues that you mentioned before, uh that involves process, scalability, execution, and then the key question for the buyer is that where they can make these businesses scale without breaking. In the commercial side, uh, you have to take into account customer dynamics as well. And customer behavior is increasingly central. And this is where more than metrics matter, it's important to check retention, concentration, cohort behavior, uh, critical issues like net revenue retention or lifetime value. And these are forward-looking indicators. I mean, nothing against actually looking backwards and your dealings, make sure that actually the track record corresponds to the reality, but we have to look forward. And to your question, it's critical for the buyer to prioritize the the issues or the key points or the criteria that's uh they have to take into account in order to make a decision. Because otherwise, they'll be actually, I mean, pretty much held back by swampy waters and trying to understand everything at once and giving the same priority order or ranking to every single issue that they come across with.

SPEAKER_00 9:45

I agree with you, and I would add by saying that it depends on how sensitive the seller, you answered it largely from the buy and the sell side, but how sensitive the seller is to value. Because we often work with companies that are so busy growing and selling customers that they may not have the robust financial processes that they wish they did. And the ability to create those processes is an investment and it takes time. And if a seller is very sensitive in on value, then distracting themselves to create those processes could be considered a waste of time if they're far off of whatever value they want to close at is. If they're comfortable with whatever value the market is offering and this owner just wants to retire, then in that case, I think you're better off avoiding those kinds of steps because it allows you to get offers and just and just move forward. So if you're sensitive about value, then don't do the high-intensity preparation sell site QOE audits. If you're not sensitive about value, then just go ahead and do them as long as you believe that your business has the sufficient complexity to warrant such a such an exercise. Ricardo, when you think about the takeaways and what our audience and the technical founder needs to consider, which is I think where you were going, what are those major things you would advise them?

SPEAKER_01 11:16

I think there are a couple of points that one has to bear in mind. Is that first of all, the due diligence is a trust exercise. It's not an audit. Numbers matter for sure, but consistency and transparency matter even more, disproportionately more. The second point is that organization signals judgment. Clean structures reflect participlined thinking. So the first year, I mean, any exercise in due diligence uh appears, it's in summary not a good sign. Third, being useful means reducing certainty under pressure because due diligence is a time-bound exercise as well. And it's, I mean, this statement is equally valid for the three sides involved: the buyer, the seller, and investment banking. That's the highest form of professional effectiveness, which could actually be manifested, and then we have a whole episode to, I mean, to eventually in the future uh cover this particular topic, because this is critical for the whole deal altogether. So, in summary, due diligence does not create value, it reviews whether the real value is actually real.

SPEAKER_00 12:35

When I think about the takeaways that technical founders should have, is there's that consideration of value, which is largely tactical. And there's also the idea that you want to make sure due diligence doesn't slow down. And so you need to make sure that you're really giving as much information as possible, particularly in diligence, but even just prior. If you think something is going to be material to a buy side decision, you don't want that to become a stumbling block after you've deployed a lot of resources during due diligence and after your company knows that you're for sale. It can be very distracting for management. Thank you everyone for listening to our podcast. I'm your host, Joshua Johanny, along with your co host, Ricardo Overlander. We look forward to seeing you on our next episode where we get to talk about the purchase agreement. Closing with confidence.