The Art of Due Diligence Part 2. Digging Down into the Details
For me, due diligence is not just a fact checking exercise. It includes an analysis of the sector in which the company operates, the team behind the company and the way they portray themselves. It isn’t a science though. Judgements have to be made and the only way to try and ensure that they are well-founded is to access as much information as possible and to rely on your analysis. This post will look at the potential pitfalls as well as the key indicators of a competent team building a company with potential. It will attempt to offer some guidance in enabling you to be as best-positioned as you can be in making an investment decision.
Companies don’t operate in a vacuum and the importance of understanding the market in which they operate cannot be overstated. There are various views of this market, from the macro high-level one to the more intimate, segmented or regional one. You need to dig down into both.
Let’s use an example: a Newco has embarked on a craft brewery. First of all, you need to understand what the product they are producing is – there are many different kinds of beer and even some being invented as you read this, by new craft brewers. The overall market size for beer consumption is not a figure that will give you any clue as to the market size for this particular brew. Find out what they produce and the direction they’re heading in, then go online and search for news items on this topic. There is almost bound to be something out there. However, don’t just read the information, try to get in touch with the author to discuss the latest developments etc. It is a rapidly expanding sector and you don’t want to be investing in a company that has chosen a part of it that is on the wane.
It is incredible how often you can come across so-called ‘market research’ in pitch decks that really tells you very little about the market the company is in. Generic figures on the global sales of hand creams do not help you understand the market size for a UK small batch, organic cream containing Kigalia fruit extract. Segmentation appears to be a lost art – either that or people are just too lazy. Like the craft brewer, whose business is not necessarily primarily in the beer mass consumption market. Many small businesses which have to diversify to create their USP will have a highly-segmented market. That is a real market of real people who really believe that their product is worth purchasing – not some numbers on a page.
Reading a pitch deck with unsegmented market information can tell you a lot about the capacity of the newco’s management.
This is a much-abused buzz word.
As an investor in a bricks and mortar business, you need to know that the model is scalable – if you want to see any return. A gym, based in London, which has plans to expand, opening new gyms across the country would be the perfect example. What are the factors you need to consider in order to make a well-informed decision?
Firstly, scaling a business is very hard – it takes considerable skill and knowledge and even more hard work. So the team in charge really does need to have, at the very least, a mentor who has this experience. It’s quite possible to scale a business to be was very successful at a certain size, but the multiplied effect of each new trading unit can leave it critically short of working capital and vulnerable to the classic SME error of over trading. It may be possible to scale but is management experienced enough to deliver it.
Returning to the gym business I cited earlier. There have been plenty of examples of fitness chains going belly-up after trying to expand too quickly. Many will underestimate the cost of opening new branches, the logistics of running them, and the ever-changing consumer demographics of different parts of the country. Gym membership is, by no means, a cheap way to get your exercise and it’s vital that the management team demonstrates that they have left no stone unturned when it comes to understanding the different geographical segments of the country, and the would-be customers who live there.
Businesses that operate online have similar scaling problems. Collecting customers online is an unpredictable exercise. For starters, how do you define a customer? I come across numerous online businesses boasting many thousands of customers. You need to know a little more about them. What is the cost of acquiring them, their longevity, their average spend and critically their retention rate? Did the company, as so many do, use a discounter like Groupon, to produce a massive surge of ‘customers’? If so, are any of them still active? You tend to find that these so called customers are just bargain hunters. They will put the company systems under enormous strain for a short period - say for example Christmas – and then vanish. Beware of pitch decks claiming impressive user numbers – dig down and check where they came from and if they are still active.
This is a difficult area. It is, however, one that can wipe out your investment if you get it wrong.
Geo-political forces are hard to predict for professionals, let alone the public at large. You only have to look at predictions for Brexit and the White House Elections to see the point. Few saw either coming.
A general rule to follow is that if there are possible outcomes that will have a fundamental effect on the business you are looking at, then you need to make a judgement on the outcome. For example, a small producer of cosmetics that relies entirely on a source of raw products from a a developing nation, needs to know that this country will have a stable government for the near future. If things were to flare up in civil war or even if it had its exports embargoed for some reason, this business would be finished, unless they have access to an alternative source. Has the team considered this?
Closer to home, you need to know what is in the pipeline with regards to regulation. This is particularly hard to predict, even as I write. Obviously, a business that relies on the EU for raw materials or sales going to EU countries, is going to be a much chancier affair for the next few years. Likewise one that intends to scale up into EU countries, needs to be looked at with great caution. You could also argue that any business relying on cross border trade between Scotland and England might face some interesting times in the next decade.
A classic example of this has been the demise of UK solar and wind energy businesses. These sprung up on the back of very healthy subsidies. The subsidies were altered or removed altogether. Revenues plummeted.
The best you can do is to be informed. Do not take what you are told by the company at face value – they are selling you their equity. Dig as deep as you can and use as many different sources as you can and this will give you the best chance of getting the right answer. If it turns out in the end that most people who voted wanted to leave the EU against the advice of nearly every politician and commentator, then there is little you – or this commentator - can do!
Who is Dexster?
Sometimes controversial, always trenchant, Dexster is Growthdeck's resident blogger. Dexster will bring you his/her views on the crowdfunding scene covering a wide range of topics, including the growth of the equity crowdfunding industry, the risks faced by platforms, how businesses are faring, what investors need to look for when choosing a provider and much more.