Effective Due Diligence – Often Harder Than You Think!

By Peter Lorange

To undertake due diligence (“DD”) when considering investing in a new project is paramount. However, in reality, to do this well can often be harder than one imagines, due both to the amount of time, energy and money required to carry out full-fledged DD, and also to the fact that a project’s promoter typically tends to set rather tight deadlines which, if not adhered to, can lead to the loss of this “great” opportunity!

Actually bringing together the two sides, a project’s management and one or more investors, is, in the end, what dictates the project’s success. Giving weight to relatively similar DD factors from both sides is perhaps the most critical factor in making this happen. DD congruence is key!

A realistic DD process should be relatively speedy and smooth, and not require excessive resources.

Finding a solid and comprehensive approach to the execution of DD can be a challenge. On the one hand, there should be enough rigour for the investor to feel reasonably confident that he/she is not taking bigger risks than necessary. On the other hand, a realistic DD process should be relatively speedy and smooth, and not require excessive resources.

How might one cope with this dilemma? Here is my own experience from S. Ugelstad Invest (SUI). A caveat may be needed at this point, before going further. Smaller, relatively entrepreneurial organisations like SUI may find some relevance in what I am about to share. Speed is very important, but it’s also necessary to be relatively rigorous and not to use resources excessively. After all, this ability to move fast may be one of the key advantages of small, non-traded firms. More extensive DD processes tend to be for larger, publicly traded firms. Here, too, there often tends to be a “political” dimension at work, namely the “cost” for a hired executive to have to take the responsibility, and at times a particular investment might not work out as hoped. For a smaller, family-managed firm, this is typically less of an issue, as roles often cross and/or are shared amongst a tight group of executives, as in the case of SUI.

My experience has left me with two sets of factors which for me seem particularly important:

  • The manager. What about the manager who will be in charge of running the venture in question? Who is he/she? Does he/she possess the required skill sets, strategic and/or operational outlook, drive, etc. to do the job right?
  • The market side. Is there a set of customers, and is the value proposition that the venture offers realistic when seen from the target customer’s side?

Before discussing each of these two considerations further, let us hasten to add that there will of course be several other issues that may be critically important, but nevertheless subordinated to the above two. We shall briefly mention several such factors later.

A. The Manager

I see a total of seven subgroups of factors here, all to be raised with the promoter of a given project:

  1. The managers track record. Has he/she been successful before? Why? If he/she has been involved in past failures, why? Is the manager’s post-job experience relevant? And what about his/her educational background?
  2. Is he/she able to inspire other people (employees, customers, etc.)? In line with this, is he/she a team player, not a super-ego person (“we, we, we” versus “me, me, me”)?
  3. Does he/she have significant financial “skin in the game”? In other words, has he/she already invested, or committed, as much as he/she can?
  4. Burn-rate discipline. Is he/she planning to run the business in a “lean” manner, at relatively low costs, only planning to scale up when success allows for this? Thus, is he/she able to manage the burn rate in such a way that break-even might be reached relatively soon? Growing too fast and/or spreading oneself too thinly may hamper the business’s potential success.
  5. Does he/she appear to be relatively flexible? Trying to stick to unrealistic initial plans for too long may be disastrous. Does the candidate show sufficient aptitude regarding learning and revising?
  6. Does he/she appear to be “honest”? This includes only asking for relatively modest personal remuneration. And spending on personal items is certainly out. As this may be hard to assess upfront, one could at least call for tight credit card practices. And is his/her compensation modest?
  7. Is the apparent work ethic of this individual acceptable or in line with the owner’s or company standards? Any issues found in the past, for instance, would count negatively.

Such an extensive set of factors is meant to help the DD assessor to get an overall general view of the manager in question. Does the manager represent something attractive, something unique, an asset? The above should not be treated as a simple, mechanical checklist, however. In the end, it is the assessor’s consolidated analysis that matters. There is certainly a degree of subjectivity here, and the assessor’s previous experience clearly matters. Nevertheless, consideration of the above seven factors may at least give some assurance of objectivity.

B. The Customer Base/Market Side

Here we pinpoint a set of five factors that we consider to be of key importance:

  1. Is there already a revenue stream, or is the proposed project nothing more than a “good idea”, i.e. an early start-up? Being able to document a specific cash flow from existing customers is, of course, important!
  2. How robust is the order book? In my opinion, the lack of an order book, at the extreme, is indeed particularly negative. But also, are we talking about “promised orders”, even wishful thinking by the manager, versus firm orders? And what is the quality of these customers?
  3. What is the attractiveness of the proposition from a customer’s viewpoint? It may make good sense to take the time to actually discuss this with several customers.
  4. Are the liquidity reserves sufficient to operate for several months? This does indeed have a great deal to do with whether this particular project is built on a solid revenue stream projection, and also on the manager’s ability to manage the burn rate, as discussed in “A-iv”. Aiming to grow too fast, and therefore spreading oneself too thinly, is often deadly! (“Strategy means choice!”)
  5. Are there any apparent threats potentially impacting the expected order flow, such as:
  • Technological developments?
  • Competitor moves?
  • Regulation?

Conversely, are there opportunities for scalability and/or to leap on to a new technology (e.g. virtual)?

In the end, what matters is to develop an overall view here, and not to treat the above as some sort of mechanical checklist.

C. Other Factors That May Also Be Critical

I have come to believe that there are at least seven factors in this category. This list is clearly not comprehensive, however. Clearly, others may focus on alternative factors in their DD analysis.

  1. Is the business scalable and/or based on the latest technology? We have discussed this already under issue B-v, but there is more. Are there other candidate firms that might be acquired and/or combined with? Is there room for relatively rapid international expansion, assuming that one’s own product and/or service is already fully developed? Is the technology grounded on IT and/or virtuality? Do they rely on commercial due diligence service?
  2. The injection of new capital is almost certainly a requirement for most ventures, i.e. future financing rounds. Who is likely to provide this capital? Are there individuals or groups among the present investors that might have sufficient financial strength to be open to such follow-on investment?
  3. Competition. How are those already established in the target niche likely to react? See B-v”.
  4. The project’s valuation. Investments have undoubtedly been made in a project already before it lands on our desk, both in terms of funds, as well as time spent by the founders. To what extent are these investments still valuable? Initial investments that turn out to represent blind alleys should not, of course, count as part of a realistic valuation. And, in general, realistic valuations are central! The promoter’s optimism and enthusiasm regarding this should not be allowed to distort what might be a realistic project valuation.
  5. Related to the above, financial injections so far are what would count. In my book, so-called investments in time and effort by the founder and others should generally not count towards a project’s valuation!
  6. Similarly, salaries and compensation, real as well as options and/or bonus-related, must be realistic, also from the point of view of the investor! See “A-iv” and “A-vi”.
  7. Is there a clear exit strategy? Here a typical promoter and/or project manager might tend to take a longer-term point of view, while many investors might look for an exit within a relatively reasonable time. Is there a plan for exit and/or for “dressing the project up for sale” within a reasonable time period, say through growth (acquisitions or internally), as well as sale to an identified entity/industry?

The above factors are typically critical indeed, and might be part of a realistic DD. Here, too, however, the key is for the assessor to come up with a synthesis, rather than treat each of the above factors as checklist items.

D. Some Examples Where Projects Did Not Work Out as Expected – Weak DD Analysis at the Roots?

In the following, we briefly list seven unsuccessful projects, why they failed in four cases and, in three more cases, why they may be failing. Poor DD seems to be at the root of all of this. For obvious reasons, the names of each specific entity to be discussed have been anonymised. Let us first discuss four projects that might be characterised as total failures.

CO2 Capture Project

We missed out in our DD primarily for   these reasons:

  • The manager was not honest and, for instance, made use of company credit cards for his private purposes. His annual remuneration was also excessively high.
  • The potential customers were large corporations, and the product the company was offering was also an expensive one. All in all, for a small start-up to offer such “big” untried solutions was not credible in the view of potential customers.
  • The product was not operational, and no orders or revenues had been secured.

Offshore Oil Drilling Project

This project was focused on offshore drilling for hydrocarbons in ocean waters west of Scotland. The project failed and DD was not done well.

  • SUI invested in the project based on the recommendations of the promoter, as well as the experience and track record of the manager. Both the promoter and the manager had some of their own funds invested in the project. There was heavy pressure from the promoter that we should decide to invest quickly or risk losing the opportunity.

Solar Electric Power Generation in Germany

This project was based on using solar-panel-generated electric energy to be injected into Germany’s electricity grid. The manager was slow and was not able to secure feasible space to install solar panels when there was a “window of opportunity” on the part of the German government. Later, this opportunity disappeared. The manager was no longer able to raise new capital.

The Beauty-Sector Project

This project was focused on developing and running beauty clinics in Switzerland and Germany, including franchising. Also, the company distributed a range of beauty products virtually. The clinics combined a focus on hair, nails and skin, and the company was the largest entity in Switzerland with this combined business. The company failed because of the following reasons:

  • Ineffective management of burn rate.
  • Too little attention to the hiring of employees by the manager.
  • A lack of overall focus.

E. Problematic Business Projects

Let us now discuss three projects that are still running, and which hopefully might work out fine. However, there were shortcomings with our DD process here, too.

The Gourmet Food Projects

This initially focused on filled chocolate medallions featuring a famous classical music composer. Later, a line of vegan chocolates was launched. A few other types of speciality products were also introduced. The target market initially was Norway, but gradually other European markets and the US, as well as China, were targeted. All production was outsourced.

The company ran into trouble for several reasons:

  • Too-wide market focus, ignoring that “strategy means choice”. In general, a lack of focus by the manager, too.
  • Too little market support on each of the key product lines.
  • Inability to raise more capital. There were no solid investors for follow-on financing rounds.
  • Perhaps in general a “me too” product idea. The first medallions were quite similar to another well-known chocolate with a different shape but similar positioning.

A Consumer Product through the Awarding of Discount Points

This company had developed its own app for consumers to follow in order to qualify for discounts regarding specific products listed on the company’s app. The company had problems making its business model work and ran into an acute cash squeeze.

  • The manager was slow in adapting, seeking ways to combine with others while the firm still had its own funds available.
  • A resistance to an emergency round of financing, implying that present shareholders, including the manager himself, would face a wipe-out.

A Used-Book Company

This company sells used books online, primarily to the Norwegian market, but also to Sweden. The company grew quickly but has yet to show a profit. The company’s situation may be seen as precarious for the following reasons:

  • The managers negotiated with two industrial players, and risked losing both, but in the end, were thankfully successful. The management team (of two) was too inexperienced, and too greedy!
  • The company has not yet been able to modify its business model to become profitable.
  • The raising of new capital, above all to support the firm’s rapid growth, was seen as difficult, especially if the industrial actor, already significant on the ownership side, turned out not to be ready to invest more.

As we can see, the DD process seems to have been less thorough than it should ideally have been in all of the seven examples given. Above all, it seems that we can trace this back to the way the manager/management team went about running its business, as well as a lack of understanding of the specific market in which each firm is operating. The revenue expectations were not realised!

In summary, our experience indicates the serious need for deep DD. Do not try to take shortcuts in your methodical investigation. Having a measure of understanding and prudence can make or break an investment. Remember to be thorough in assessing all the aspects of a potential acquisition (customer/market orientation, the manager, financial, legal, operational, organisational, etc.), but, as indicated, the factors around the manager and the market side may be the most critical in determining the benefits, liabilities, risks and opportunities. We live in a complex world, and a good DD can bring clarity and a more unbiased review of the opportunity at hand, as well helping the investor both to determine whether the proposer’s assumptions are true and fair, and to discover unknown issues.

About the Author

Peter Lorange, after having sold his shipping company in 2006, has been a successful entrepreneur and owner of a highly diversified family office.  He has been regarded as one of the world’s foremost business school academics, holding the position of President at IMD, Lausanne for 15 years, as well as several positions on shipping company boards. His entrepreneurial journey spans across key areas such as education, shipping, investments, and pre-dominantly Family Businesses.  Peter founded the Lorange Network, a digital learning and networking platform, in 2017.  Peter is Norwegian, residing in Küssnacht am Rigi, Switzerland.


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