The Ultimate Guide to Operational Due Diligence

Operational due diligence may be the most forward-looking kind of due diligence that exists.

The aim here is not to look over several years of past performance, but rather to project into the future and assess how value creation will be sustained into the future with the target company’s operations.

Hundreds of DealRoom clients conduct their operational due diligence using our M&A platform, allowing them to take advantage of our operational due diligence template.

In this article, we look at how to conduct operational due diligence, as well as providing a checklist of the items that require attention to ensure this part of your company’s due diligence process passes successfully.

Buy-side operational due diligence

As with any aspects of due diligence in the M&A process, most of the discussion tends to center on the buy-side.

Buyers look at the operational side of a target company and think

“if this was ours now, how could we make it work?”

As mentioned at the outset of this article, operational due diligence is forward-looking for the buy-side. It’s not looking at the past five years of production (in the same way that financial due diligence looks at past financial results).

Rather, it’s seeing if the operations of the target company will be sustainable in the coming years.

Sell-side operational due diligence

Because operational due diligence is forward looking, in some ways it resembles a strategy for a company’s operations.

In this regard, it pays any company on the sell-side to conduct its own operational due diligence - a kind of critical analysis of how the company’s operations are functioning. This is something a company should be performing, even if a sale of the business isn’t immediately on the horizon.

• Do your machines require investment?
• Are you going to need to extend your capacity?
• Could your operations run more efficiently in some way?

All questions that have the potential to generate significant value for a business.

Operational due diligence framework

Like any other form of the broader due diligence process, the best way to approach operational due diligence is by using a framework.

This provides your due diligence team with a better platform for performing their tasks. It also ensures that the virtual data room associated with operational due diligence is structured in such a way that information can be accessed (or requested) faster.

A strong framework should look something like the following:

1. Target Business Model
2. Human Capital
3. Intellectual Capital
4. Long-Term Assets
5. Risks and Mitigating Factors

Below, we look at each of these in more detail:

1. Target Business Model

There is some misunderstanding of exactly what the ‘business model’ is, even among experienced investors. A company’s business model is how it generates cash flow. That’s an important distinction.

So, for example, if the company has an extremely long inventory cycle, it means significant amounts of its cash are tied up in its inventory for a long time - a concern for any investor.

The easier it is for the company to generate cash, all things being equal, the more attractive it will be for investors.

This is one of the main reasons why investors love SaaS platforms: they provide recurring (i.e. predictable) cash flow on a monthly basis, with very little marginal cost per new consumer.

Also, with no inventory, that cash can be put to more productive use.

2. Human Capital

Although a significant chunk of the due diligence process should be devoted to the human capital element of a target company in its own right - through HR due diligence and change management - this needs to be considered from a purely operational basis.

Essentially, to what extent does the target company’s people contribute to successfully carrying out its operations?

Clearly, this is less important in some businesses than in others (say, an architecture firm versus as compared to a heavy manufacturing firm), but it needs to go deeper than that:

• If sales have increased in double digit figures over the past two years, is this a brilliant salesperson?
• Is the success of a business because of  its service level  or its mercurial owner?

All crucial questions.

3. Long-Term Assets

Broadly speaking, the more dependent a company’s operations on its long-term assets, the more important they are to conduct due diligence of.

Although nobody should be fooled into thinking that just because the company doesn’t have heavy equipment on its books that its long-term assets aren’t important: Computer hardware is now a vital component of most businesses’ operations.

4. Risks and Mitigating Factors

What is due diligence if not a means to identify and mitigate risks? Operating risks are arguably the biggest a company faces in a transaction after financial risks. The list here is potentially endless but some questions that should be asked include:

• What factors could prevent the company from continuing to operate at its current capacity when the transaction closes?
• Is there anything in the target company’s current operations that conflicts with how our business operates?
• How have the target company’s operations evolved over the past five years and how do they compare with the industry’s best-in-class?
• Is there any way that we could quickly and cost efficiently improve this company’s operations in a short period of time?

The operational due diligence checklist

Operational due diligence is where a virtual data room or complex diligence management software such as DealRoom comes into its own.

The nature of operations is that all manner of seemingly unstructured and yet, completely warranted questions can be asked during this type of due diligence that it pays to ask them on a platform that gives them some structure.

The unique request function in DealRoom is custom-built for better operational due diligence. Here is how the requests could be organized.

Btw you can utilize and pre-fill your workspace with pre-made operational due diligence playbook, the part of which is listed below.

The following operational due diligence questions represents a decent checklist for anybody about to begin the process:

1. Initial assessment of the target company operations

1. how well do the operations of the target company fit with those of the buyer?
2. What synergies/conflicts exist between the buyer and the target company?
3. Are there any ‘quick wins’ that can generate value?
4. What kind of (capital) investment will be required to bring the target company operations to the desired level?
5. How sustainable are the operations? (i.e. are they running near capacity, using old technology, too expensive to be sustainable, etc.)

2. Document review

1. Check internal procedures
2. Check company compliance 
3. Check relevant licences and subscriptions
4. Conduct review of technology underpinning operations
5. Conduct review of intellectual property (if applicable)
6. Benchmark KPIs of the operation against industry competitors

3. On-site visit 

1. Make an overall assessment of the company’s as-is operations (“if we were to buy this company today, what would change in these operations?”)
2. In what condition is the factory/office/logistics center and its technology/equipment/machinery?
3. Interview operations managers
4. Interview relevant players upstream and downstream in the supply chain (e.g. suppliers, distributors, service providers, etc.)
5. Are there any backlogs or bottle becks immediately apparent at the target company site?
6. How easy would planned performance improve strategy be to implement given the current operations?
7. Assess the culture at the on-site operations. Is it structured or ad hoc? Is there one manager or is everybody making autonomous decisions? Are there any health and safety issues that need to be addressed?

4. Projections

1. Use information gathered until now to make projections about the value added that your company can bring. Can it generate more value from the same machinery/technology? Is there any value in having this extra capacity?
2. Work with commercial and finance teams to build a budget based on the operations of the target company.
3. Work with the finance team to estimate synergies that could be generated from a merger or acquisition with the target company.

The full checklist could be found in our M&A templates gallery.

Conducting operational due diligence with DealRoom

Whatever your operational due diligence needs, DealRoom’s platform is versatile enough to cater to firms of every size in every industry.

The process has also been designed so that anybody can set up their due diligence software within a few clicks:

1. Request a demo and setup an account with product specialist

2. Choose an operational due diligence template from the playbooks gallery

DealRoom has a range of templates for different due diligence functions - each one created based on feedback from experts in the field, and specially tailored to a particular kind of due diligence.

3. DealRoom provides prompts for information through its unique Requests feature.

The uploaded documents are then stored in a safe environment and linked to the relevant requests.

It is that simple. Whether you’re operating on the sell-side on an oil and gas industry deal, the buy-side on a fintech deal, or as an intermediary in a merger between two manufacturing companies, DealRoom will add significant value to your due diligence efforts.

Conclusion

Operational due diligence is a thorough investigation of the target company, what it does, and how well it does it.

The nature of this aspect of due diligence is that every company will generate its own set of questions specific to it.

That spontaneity demands that everybody conducting operational due diligence uses a virtual data room to give structure to a process that can easily become unwieldy.