My Due Diligence Soapbox
Big Deal Small Business, Issue #107
My Due Diligence Soapbox
Big Deal Small Business, Issue #107
Do you know the difference between doing something dangerous versus doing something hazardous?
We think about this a lot at my company – as many of you know, I operate a tree service contractor. Our work involves our highly-skilled arborists climbing trees that are some 60’, 80’, or 100’+ tall.
This work is hazardous. But it is not necessarily dangerous.
A hazard is something that could hurt you on a job site. Electrical lines. Hanging branches. Vehicles driving by.
A danger is when you are now actually in harm’s way. The hazard is out of your control. You chose to be within 10 feet of the electrical line, so getting shocked is out of your control, just a function of gust of wind.
You are positioned directly under the hanging branch with no escape route.
You stepped off the curb and a car driving by couldn’t see you.
A hazardous activity turns into a dangerous activity if you do not take the time to 1) identify, and 2) mitigate the hazards before starting the activity.
In tree work, this means maintaining a 10-foot minimum approach distance from high-voltage lines. Anything closer requires the power utility to clear the lines before we climb the tree. We identify the hazard, and mitigate it.
It can mean avoiding the hazard entirely – we climb from a different side of the tree so that we are not directly under the hanging branch. It’s no longer a hazard to us, so we will not end up in a dangerous situation.
We put cones & signs out near the work area, advising cars that there are workers along the road. We wear high-visibility clothing. We identify the hazard and mitigate it.
Stay with me – I assure you I will bring this metaphor home.
No Perfect Deals
Sometimes as I listen to Acquiring Minds’ podcast episodes, I’m terrified on behalf of the guests.
They bought what? They didn’t bother with a Quality of Earnings? That seller seems so shady…
And then I compare that to a common refrain I hear in search: “There’s no such thing as a perfect deal.”
I’ll put my hand up – I say it too. I have a whole post dedicated to how you have to compromise in order to close a deal (guest-written by good friend Bradley Roofner).
However, I am noticing a worrying trend – people are using “no such thing as a perfect deal” to justify just about any risk in their deal.
No! Just because there’s no such thing as a perfect deal, the inverse is not automatically true – there is indeed such a thing as a bad deal.
There are poor quality companies that should not transact, at least not to a searcher. They will fold once the owner retires, or a local competitor will buy their client list.
So what is the purpose of due diligence?
I have seen many answers:
To answer your key questions to know if you want to buy the business or not
To confirm if the business is actually what the seller says it is, from checking if the earnings are real to if the clients are actually loyal
To prepare for a smooth transition
To convince your lender or investors to finance the deal
No. No, no, no.
The purpose of due diligence is to kill the deal. That’s it. It’s to uncover a danger that you cannot stomach, mitigate or avoid.
You define upfront what risks you are willing to stomach in a deal – what risks you feel comfortable managing even though you know they could become dangers. That’s what Bradley and I tried to outline in the Compromising to Close post.
Your personal criteria for an acceptable deal should be clear to you BEFORE you underwrite any given deal. It’s not deal-specific.
When you submit your LOI, you’re stating that, based on what has been presented to you so far, the deal meets your acquisition criteria at specific terms.
The moment your LOI is accepted, two parallel processes begin:
Closing Process
Due Diligence Process
The Closing Process involves lining up financing, getting legal papers in order, clearing liens, hiring an escrow agent, etc. These are the mechanics of getting a deal closed.
The Due Diligence Process is simpler: you now have full access to the company, so your job is to turn over rocks to see what’s underneath them.
You don’t limit yourself to the rocks that are obvious, sitting in front of you. You search for every rock in every place you can think of, and turn it over.
I had a boss in private equity who phrased it well: “Your job as a private equity associate is to turn over as many rocks as you can, until we run out of time and the deal closes.”
You don’t slow down the Closing Process (unless you find something material in due diligence that warrants a pause) – you constantly move efficiently towards closing the deal, or it may just fall apart.
Instead, you work hard & fast on the Due Diligence Process. Even if you are hoping and praying that you won’t find that one thing that kills the deal. Even if you really just want the deal to close.
You know what you really do not want? You really do not want to find that one thing the day after you sign a multimillion-dollar personal guaranteed loan.
My Due Diligence Soapbox
Just like tree work, acquiring a small business is an inherently hazardous activity. There are dangers lurking around every corner. There is no such thing as a perfect deal.
But that doesn’t mean allow an inherently hazardous situation turn dangerous due to your own carelessness.
Yes, you won’t be actually be able to identify and mitigate all the hazards – you may still end up in a dangerous situation. But during due diligence, your job is to try to identify and mitigate all hazards. It is unacceptable to put your hands up and say “well, there’s no such thing as a perfect deal.”
Quick Aside: I’ve been working on “un-learning” many of my work habits from my private equity days. Those work habits are intense at best, unhealthy at worst. I’m working on finding balance.
But there is one glaring exception — I am not changing my approach to Due Diligence. I’m sticking to my PE ways when it comes to Due Diligence.
You do not rest during the Closing Process – the Due Diligence Process is a death march to the finish line. You just fall across the finish line as you try to turn over one last rock.
If you have that weird inkling of a bad feeling, that loose thread you’re not sure about…chase it down. Don’t let that thread stay unexamined for fear that it may kill the deal.
To be clear – this doesn’t mean you end up with a perfect, undangerous deal. You will invariably fail to identify some hazards. Even for those you do identify, your mitigation plans may prove misguided. I certainly missed or miscalculated material risks in my deal, and that’s with years of experience doing high-octane due diligence.
But you do your best, which earns you the right to say that you took a calculated risk.
Searchers & acquirers – your job is to take a calculated risk. Your job is not to just take any risk. That’s dangerous, not heroic.
Okay – getting off my soapbox now.
Happy Saturday everyone!
Thanks,
Guesswork Investing
Great perspective! Thank you mate.
Nice piece, great insight.