Operational Diligence

The return on a Direct Private Equity deals is completely based on the sustainability and growth of the business over the investment period.  Operational diligence picks apart the business model, isolates the key drivers of revenue and profit, and then models out how those drivers may change over time.  Once you know the drivers of value – it becomes far easier to drive company results as it simplifies the process significantly. 

Operational due diligence is about understanding what needs to happen for the business to function in a sustainable way despite the normal ups and downs of business.

The key elements of the target’s operating model:

Revenue Drivers:  Revenue drivers are the assumptions that go into a single sale.  We build a model that shows how each revenue dollar is generated and then aggregate until all revenue for the target business is accounted for.  Whether the target company provides a produce or a service – there is a build up of Units Sold x Price = Revenue.  But it is often not as simple as it looks because there can be multiple business lines, both products and services being sold, and one product may drive sales of other products/services such that the individual business line revenue models are inter-connected.  You’ll know you have a good revenue model when you can input a finite set of inputs into the model and arrive at the revenue for the last period.  Guardian’s revenue model will give you complete clarity on the exact elements that drive sustainable revenue to the company.    

Cost Drivers: Cost drivers are all the areas where a company must spend in order to generate its revenue.  Not all costs are the same.  Costs associated directly with the sale are considered Cost of Goods Sold (COGS).  Other costs needed to run & manage teh business are captured in Sales General & Administrative Costs (SG&A) along with indirect costs that are included in Operating Expenses.  For each cost line item we build a model that shows what drives that cost up and down.  Some costs will increase as revenue increases.  Others will have some other driver like choice of office location for rent, number of administrative employees driving overhead costs, or plant/facility costs that cannot be turned on/off quickly and those costs must be accounted for differently. Guardian’s cost model will give you complete clarity on what drives all the costs in the business.  

Drivers of Sustainable Profit Over Time:  The profit model is now a function of the revenue model net of the cost model.  But the process is not done.  Business buyers need a view on how sustainable the revenues and profits will be over long periods of time – sometimes 5+ years.  Guardian will consider market forces and trends and identify key risks to the sustainability of the profits.  Also, the competitive landscape will be analyzed to see what competitive forces coming from other companies may impact profits.  This process is part operational analysis and part strategic analysis.  Guardian’s sustainable profit model will include a view on current profit, a view on long term profit (5+ years), and a competitive landscape analysis to identify key competitors and how to mitigate any threats coming from them.

The key elements operational due diligence:

People:  Are the people inside the acquisition able to sustainably deliver the output of the business in order to keep and grow profits over the long term?  If not, how can the buyer mitigate that risk?  And what will that cost do to the buyout model and ROI?

Process:  Does the business have documented and repeatable processes?  Most companies under $20 million in revenue do not have documented processes so part of the job of due diligence is to consider the mission critical processes inside the business and think about how those processes will perform under new management and how can you move towards documented processes.

Technology:  If technology is the differentiator in the acquisition target’s business, then this becomes the main topic for operational due diligence.  For other businesses, technology is a key support mechanism for the business.  Compared to “best practices”, how good is the target’s technology platform?  What would the cost of improving the technology be  & what is the ROI of that investment.

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Revenue Drivers

Revenue drivers are all the assumptions that go into single sale in each business line the target has.  Those business line revenue models are then aggregated until all revenue is accounted for. 

Cost Drivers

Cost drivers are all the costs that are needed to deliver on all the revenue that company generates.  There are direct costs that are capture in Cost of Goods Sold (COGS) & Sales General & Administrative Costs (SG&A) along with indirect costs that are included in Operating Expenses.

Sustainable Profit Drivers

The profit model is now a function of the revenue model net of the cost model.  But the process is not done.  Business buyers need a view on how sustainable the revenues and profits will be over long periods of time – sometimes 5+ years.

People

Are the people inside the acquisition able to sustainably deliver the output of the business in order to keep and grow profits over the long term?

Process

Does the business have documented and repeatable processes?  If not, part of the job of due diligence is to consider the mission critical processes inside the business and think about how those processes will perform over time. 

Technology

If technology is the differentiator in the acquisition target’s business, then this becomes the main topic for operational due diligence.  For other businesses, technology is a key support mechanism for the business. 

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