Well-executed financial due diligence is one of the most effective means by which a private equity firm, and especially its operating partners, can mitigate risk and drive returns. The ability to draw and support important deal assumptions despite ambiguity can distinguish firms from one another and determine success or failure in a bidding process.
Developing a view on the revenue landscape of a company is first in order of importance when conducting financial due diligence. It typically provides key insights that can be used to assess the company’ capabilities and activities against the functions most valued by customers.
How are salespeople incentivised?
Sales compensation plans can be powerful tools to direct sales resources to focus on particular attributes of the business. The structure of plans also provides an explicit framework for salespeople to optimise their own compensation. A salesperson with a compensation plan focused exclusively on revenue dollars who also has the ability to affect price may sell products at a lower margin towards the end of a particular month, quarter or year in order to meet compensation plan targets. A purely gross-margin-driven plan will result in high gross margins on potentially low sales dollars.
Often, a seller’s case for an increased future value of its business is predicated on its successful entry into new markets. New markets may be defined as geographic diversification using additional sales channels or previously unexplored go-to-market methodologies. The company may also enter new markets through product development efforts to access the markets it previously could not serve.
Are there too many products?
The profitability of future revenue forecasts can be affected by increases or decreases in the actual number of products or product varieties sold. When analysing the products sold by the company both today and those expected to be launched (and contribute significant revenue to future periods), note that maintaining a certain number of product lines carries its own costs.
Can cost increases be passed on?
Early in the due diligence effort, develop a view of the cost/price dynamics faced by the target company. To perform this analysis, the impacts of price changes, product mix shifts, material costs and even currencies must be largely isolated.
Modelling labour cost requires understanding where employees are located, the functions performed and the categories of cost included in total labour cost. Hourly employees, salaried employees, contract workers, temporary labour and terminated employees with ongoing costs should all be considered. Pay attention to benefits such as pensions.
Lease obligations are often held flat over model time frames. However, a review of key lease provisions will provide the information required to correctly model increases over the remaining life of the lease.