Due Diligence – Unlocking Value for Companies and Investors Alike
Due diligence is a powerful tool both for investors and, if used effectively, for the (prospective) portfolio company. Prominent collapses of tech companies such as FTX, Theranos, Celsius, and BlockFi have prompted observers in many circles, including the Financial Times, to ask “Doesn’t Anyone Do Due Diligence Anymore?”. The thoroughness of diligence has observably declined as a result of the heightened investor enthusiasm of the last few years — we have seen investors forgo not only operational and technical diligence, but even the fundamentals like accounting diligence and background checks. This makes sense in some contexts — diligence is expensive and time consuming, and if one’s ability to close a seemingly attractive investment is dependent on the ability move quickly, there will be (and has been) a race to the bottom on diligence. However, both the investment firm and the target company are missing a major opportunity to materially improve how the investment operates.
“Move quickly and break things” has long been the mantra in Silicon Valley and the broader tech world. This philosophy has fostered the creation of some truly amazing companies. These rapidly growing companies are building systems and processes on the fly by necessity — many of the things that they are doing have never been done before. Customers appreciate the innovation, as demonstrated by the rapidly growing users and revenue which these companies garner.
And while companies have focused to this point, rightfully, on growing their businesses, there are also problems left from this approach which we discover in diligence. Though it is rare, diligence can uncover red-flag issues: tech that is unstable, economics that just don’t work when the onion is peeled back, or fraud. But more often, there are fixable issues which can be addressed now but could be fatal if left unchanged. Our diligence efforts have turned up systems which were adequate for today’s volume, but which had bottlenecks that would choke the system if volume doubled; gross margins which didn’t include key variable costs which would lead to misallocation of resources; inadequately configured tracking systems that were understating the cost of acquisition in certain channels, also leading to a misallocation of resources. These often appeared in companies that were highly valuable despite those issues — but fixing them would further increase their value, sometimes massively.
Proper diligence can present an incredible opportunity for the target company. When Centana and other investment firms conduct thoughtful diligence, we bring a number of experts to the table, from technology to go-to-market and accounting, as well as advisory board members who have built or run companies in similar areas, bringing an outsider’s perspective. We take a meaningful part of our time to comb through their reports and talk to the advisors to extract and consolidate their thoughts and recommendations. In the end, we have a set of recommendations that may have taken much longer (if at all) for a company to come up with on their own (because the company is focused on the hand-to-hand combat that is the daily life of a startup — developing great products and working with their customers). Literally hundreds of thousands of dollars are poured into diligence reporting. Taking the time to extract the observations and recommendations from those experts is an extra step that takes even more time and money — but the results produced by this process are invaluable.
Every Centana diligence engagement ends with both a 180-day plan and a longer term set of recommendations from the advisors and experts, both internal and external, that we have engaged. This transforms what was once a drudgery —a zero-sum game and a one-sided experience — into a value-creating experience for both sides of the transaction. The company gets a set of recommendations by outside experts on operational, technical, accounting and HR for their business. In the end, these are just recommendations. Management has the option, and the responsibility, to decide what needs to be implemented and how to prioritize those recommendations amongst the myriad of other priorities which they inevitably have. But the results can be truly transformative for the companies — making valuable companies even more valuable. And while the diligence process still does consume management time (we work to minimize that, but haven’t found a way around it yet), all stakeholders including management end up with the benefit of those hundreds of thousands of dollars spent and the experts’ time, and a pathway to an even more valuable company.