Pre-LOI due dilligence

July 17, 2023

by a searcher from University of Virginia-Darden - Darden School of Business in Charlottesville, VA, USA

I'm trying to build out a checklist for myself of what info I need to be ready to submit an LOI. Below are my initial thoughts. Does anyone have any suggestions? Or a checklist they've found online that they like?

I know there's no one-size-fits-all question set, but I'm trying to give myself a head start on any new deal and increase my odds of getting all the important info.

1. Revenue: one time or recurring? what's the cash flow cycle, i.e. does the company get paid before or after they incur variable costs associated with a new order? does any one customer make up 20% or more of revenue? how frequently do customers leave?

2. Pricing: who are the other competitors and how do they price? How often does the company change prices? How much pricing power do they have? Is there evidence that there is a shortage or surplus of demand in the market?

3. Cost: how much power does the company have over suppliers? what makes COGS vary? what is the cash flow cycle for costs?

4. Margins: what puts downward pressure on margins? what are the top 1-3 costs to control?

5. Unit economics: what are the top 1-3 sale/marketing channels? is there data on the customer lifetime value and costs of customer acquisition for each channel? what opportunities exist to increase gross margin?

6. Management: is there a management team in place? what's their tenure? if I want to grow, who's the next key hire?

7, Labor: how big is the team? what is the average tenure? how easy is it find team members with the necessary skill set? what is the risk of labor leaving to start a competitor? is there any training program in place?

8. CapEx: what capex is required to maintain the current size, and when? what CapEx is required for growth?

9. Competition & barriers to entry: how does the company differentiate itself? what will attract more competition to the industry and what are the barriers to entry? ? how does the cost of entering as a new competitor compare to acquiring an existing company?

10. Seriousness of seller: is the asking price reasonable? does the seller have legitimate motivation to accept an offer?

11. Market dynamics: does the industry have headwinds or tailwinds? is the product/service an offering people need vs. want?

Reply by an investor
from University of Illinois at Urbana in Chicago, IL, USA

Thanks Luke. Suggest taking advantage of thing's such as Lisa's generous offer and other online / connections resources. Lisa is correct, those are two huge issues out of the gate. As you drill down, one tool I like to use is a long diligence session that focuses on the trail "from quote to cash". That is, start off with a potential opportunity/new customer for the business and as questions, listen, take detours and detailed notes - all the way until you get to payment by the customer - or "cash". This interrogative will help you understand why someone might buy from the company, what alternatives they may have considered, how the opportunity gets processed by the company. - who needs to be involved? why? what business systems/tools? who makes decisions? etc. etc. If you understand how a potential customer goes from quote to cash - even at a high level - you should understand the business much better, and understand whether it deserves to exist and win long-term. Finally, suggest looking for "competitive moats" - this is a Buffett concept that can help a business grow - and as importantly not go away. If a business has not true competitive advantage, or if it lies with the seller(s) - be very careful.

Reply by a searcher
from Western Michigan University in Grand Rapids, MI, USA

You are correct that there is no list that fits every deal and having a long list of requests right away can cause the seller to feel like you are interrogating them rather than getting to know their business.
My personal preference is to take a phased approach pre-LOI. Determine what things, if they existed in the business, would make it easy to pass on the deal. Those should be some of the first things you look into. For example, if you are not planning on operating the business, details on the management team should be on your list.
I think the thing that some buyers lose track of is you want to buy a business that fits you (or your team). Some buyers are looking for distressed businesses so financial performance might be less important while others need a business producing at least seven figures of free cash annually. Your list should fit the criteria of what you are looking for.

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