11 Steps in Search Fund Due Diligence

Right out of business school you can buy a company? Even if you have loans and limited funds in your bank account? Yes. Yes, you can.

Coming out of business school “entrepreneurship by acquisition”, also known as “buying a company”, is a possible career path.

How does it work?

A student identifies “search sponsors” (your intended first investors), the investors provide money to “sponsor your search”, and with those funds you spend the next 0–24 months looking for a company to purchase. The money to buy the company comes from a combination of bank debt and the sponsors who decided to invest.

But the tough part…

What do you consider when buying a company?

Here are a list of suggested activities I have identified from taking the course, Financial Management of Smaller Firms (FMSF) and speaking with Harvard Business School (HBS) professors “Rick and Royce”.

Review key attributes

  1. EBITDA margins — What are the EBITDA margins? If they are in the single percentages versus 20–25%, that is a flag. Businesses with higher margins are more attractive and are an indicator that there is a natural barrier to competition which allows companies to charge a premium.
  2. Year over year trends — Has the revenue been steady, grown, or declined? Companies with steady or growing streams of revenue from a constant set of customers is attractive and indicates ‘stickiness’ of the product or service.
  3. Changes and cyclicality — By looking at the ‘unit income statement’ (converting the income statement into percentage of revenue by year) you can view changes in proportionality over time. Make sure you understand why key shifts occurred and how the business can change. Also look at the performance before and during the last recession to understand the resilience of the business in tough times.
  4. Customer concentration — Compile a list of customers and the percentage of total revenue they represent. A low number of customers accounting for a large percentage of revenue is undesirable as it dictates dependance on a small concentrated pool of clients.
  5. Capital requirements — Does the business have high or low capital requirements? Will key equipment require replacement soon? Understanding the capital requirements will enable you to estimate how much money the business will absorb as you push for growth. The lower asset intensity, the better.
  6. Replaceability of employees — Are employees replaceable or do many of them have specialized knowledge that is key to running the business? Having an employee base where there is not a high amount of specialized knowledge incase employees need to be replaced is attractive.
  7. Resilience of the business — Create a financial model to estimate scenarios to understand the financial inner workings of the business. Make sure run the following scenarios and understand how EBITDA changes: zero growth over time, increase in COGS, and increase in SG&A. What is the worse case? Best case? For each scenario calculate the total enterprise value (TEV = EBITDA * multiple) and the debt over TEV.
  8. Assess the capital structure — Review the current amount of debt and the capital structure needed to purchase the business. What are the funding sources needed to purchase the business? Who is the senior debt provider? Who would be second? Who would provide an equity investment? What is the total interest payment required annually and what sales and EBITDA are required to cover that base interest? If the business is going through rough times, what are the incentives of each lender/investor? Would one of them push to exit before the others? Understanding your required capital structure and the incentives and motivations of investors are key.
  9. Review key documents — Request financial statements, CIM (Conformation of Information Memorandum), and invoices tied to the accounts receivable and payables.
  10. Conduct interviews — Do a site visit, interview the founder, employees, vendors, customers, and competitors to understand how the business ticks.
  11. Estimate outcomes — Using the financial model and anticipated capital structure estimate the IRR for each investor under the different scenarios. Do not assume a multiple expansion from the current purchase price to exit. Multiples are based off market forces beyond the businesses control, its easiest to keep them constant.

This list should get you started.

Ready to buy a business?