The Due Diligence Checklist

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					The Due Diligence Checklist1
In an uncertain world, due diligence provides ‘risk insurance’ for a
strategic alliance’s partners and investors.
By Arthur H. Solomon,
Managing Director – North America/Europe
East-West Alliances


Changing institutions and accelerating technological innovation are creating exciting
business opportunities for new entrants as well as for established players, and are
stimulating unprecedented demands for products and services that drive the
development and expansion of communications, information technology and electronics
industries around the world.

Rising Innovation Needs + Increasing Uncertainty = Greater Risk
As these sectors continue to expand globally, competition for growing markets and the
new products needed to exploit them result in greater risk-taking, and makes the need
for rigorous independent ‘due diligence’ review by knowledgeable, disinterested experts
increasingly critical.

A cursory look at a business plan’s numbers or a high-level market forecast in a
concept memorandum is not sufficient to ensure a ‘win-win’ result from a strategic
alliance. In today’s fast-changing world, complexity and uncertainty dominate
business projections, and alliance plan evaluation centers around recognizing and
taking into account the uncertainties and risks.

Answering the Questions

A thorough independent business plan review can reduce risks for everyone involved.
An independent expert review should be an integral part of the planning of any
international alliance or other major venture for the benefit of all parties. For example:

•   Alliance "champions" (entrepreneurs, business unit managers, etc.) may learn
    valuable information from the review and the recommendations of the reviewers.
    As a result, the champions may be able to change questionable assumptions or
    avoid previously unforeseen pitfalls, and increase the prospects for success.
•   Corporate approvers (CEOs, Boards of Directors, etc.) may find comforting
    reassurance if consultants’ findings are positive — or relief at avoiding a costly
    mistake if the findings persuasively demonstrate the flaws in the prospective
    alliance.
•   They can be guided by the consultants’ findings and recommendations in order
    to negotiate changes in the alliance plan with their prospective partners that may
    lower their risks or, if that cannot be accomplished, cause them to decide not to
    proceed, and thus avoid likely future difficulties and write-offs.



1
 This paper is adapted from “The Due Diligence Checklist”, by the author, which originally appeared in
Telecommunications Investor, June 1999.
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When assessing the prospects for any type of venture or project, sponsors tend to focus
on anticipated rewards, while underestimating the risks. Pitfalls lurk in the paths of
almost all projects, but by looking at them objectively, changes usually can be made to
avoid pitfalls or mitigate their impacts. In our experience, very few ventures that were
referred to us for review — after first being scrutinized by corporate management and/or
investors — were poorly conceived. However, many ventures were riddled with
potentially serious risks that could be avoided. The highest value of a consultant’s
review is in identifying the risk factors and recommending changes to eliminate them or
mitigate their impacts, thus increasing the chances for success.

The Due Diligence Review Checklist

Traditionally, due diligence studies have focused on market and technology risks.
However, the viability of a venture between prospective partners coming from different
backgrounds, cultures and business environments often depends just as much on other,
less obvious, factors, such as the skills of the team in managing complex projects during
the initial alliance stage and the abilities of the organization to effectively manage all
phases of operations after the startup, including R&D, marketing, sales, production,
logistics and customer service. A proper understanding of the local legal system and the
pros and cons of the regulatory framework also must be understood and the risks and
uncertainties managed, especially if the venture is with a firm in a foreign country.

A checklist for reviewing an alliance business plan should consider all of the following,
whether through rigorous ‘tire kicking’ by the potential partners and their investors, or
by independent outside experts, or both.

Item No. 1: Market Risk

"If we build it, they will come" may be firmly believed by the project champions. But
faith alone seldom will convince a board of directors to put the business at risk. Rather,
a detailed quantitative market projection is needed, taking into account historical and
expected growth trends, competition, price and cost trends, legal and regulatory issues,
and, if applicable, political risk factors.

Insightful ‘bottom-up’ models — which analyze the various individual trends in
applications and competition that drive use of products and services — are preferred to
simpler ‘top down’ approaches, which focus on forecasting overall market growth by
extrapolation of past data. Interviews with key customers can give added credibility to
forecasts and market share estimates, especially when the business plan assumes that
success will be achieved through unique differentiating price or performance features.

After data are collected and analyzed, assumptions must be made to project future
market performance. Assumptions imply uncertainties; those that will have
significant impact must be identified and evaluated. For example…
• Will the planned alliance create new markets for our products, or expand
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    existing ones, sufficiently to justify the risk of uncertainty inherent in any
    partnership?
•   The timing and extent of the expected market share and revenue gains usually
    represent significant uncertainties. Will gains come as expected, and soon
    enough to compensate for the inevitable costs and distractions of the alliance
    start-up period?
•   A major attraction of the alliance may be that it will save the substantial costs of
    developing new products necessary for growth by exploiting products and
    technologies offered by the partner. How sound is the reasoning here?
•   If it is believed that economies of scale resulting from combining some
    operations will equate with a lower cost structure, then what will be the impacts
    of alternate market scenarios about price and margin trends? Will lower
    industry-wide costs lead to steeper price declines in a highly competitive
    market?

Item No. 2: Technology Risks

The last one into the game can always leap ahead of those that came before, but having
the latest technology gives no guarantee of a sustainable competitive advantage.
Business plans that rely heavily on acquiring a technological edge should be examined
closely. It is particularly important to test whether the technology choice allows
sufficient flexibility to accommodate a range of potential future changes. A business
plan should take into account the uncertainties associated with the timing of the next-
generation technology and the possible obsolescence of planned new products.

When the alliance partner is expected to contribute significant technology assets or
resources, a rigorous review and evaluation of the prospective partner’s intellectual
property and technology resources should be an important part of the due diligence
process.

On the other hand, a project plan that takes a gigantic leap in technology may be
especially risky. Great fortunes have been made by those who venture into the market
with a better mousetrap; however, most investors prefer to back ventures that rely on
more proven technology and leave the pioneering to those with missionary zeal and
stronger stomachs.

Item No. 3: Alliance Implementation Risks

Often, a sound plan goes awry in the initial implementation phase, usually for one or
more of the following reasons:

•   Inexperienced implementation managers. Alliance sponsors generally focus
    heavily on planning, financing and other preparatory tasks; however, at the same
    time they may neglect to bring onto the alliance start-up team people
    experienced at getting the necessary implementation tasks done and the project
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    management resources to support them. This can lead to delays, cost overruns and
    missed market opportunities.
•   Underestimated critical path times to complete. Implementation plans that seem
    to be complete and well organized may err in underestimating the time needed
    for certain tasks.
•   Inadequate or unrealistic market rollout plans. Often, attention is focused more
    on building the organization than it is on launching the business. As a result,
    marketing and sales processes and materials are delayed or neglected. Customer
    care systems are not given adequate thought in the planning stage and later turn
    out to be inadequate, faulty or late (or all of the above). Sales people who know
    the business and the local market may be in short supply. Distribution
    agreements with outside partners may be badly written or delayed. All of these
    can cause higher costs and lost market opportunities.

Implementation tasks should be addressed fully in the business plan. A comprehensive,
realistic action plan covers all issues, with adequate allowances for contingencies.

Item No. 4: Operational Risks

The business plan should describe plans for the alliance’s startup and initial operations
in sufficient detail to give confidence that it will be smoothly launched and well-
managed at the outset. A clear picture should be provided of how the alliance will
become a high-performance business. Here, aside from overall strategy, are several key
risk factors:

•   Insufficient or inappropriate human resources. The wrong people in key
    positions can hobble an otherwise first-rate operation — so can too many of
    them, or too few to handle the growth of the business. Combining staff smoothly
    and effectively is a key task in launching the alliance and keeping it growing.
•   Inadequate capital for growth. Another frequent cause of distress in new or
    expanded businesses is inadequate working capital or insufficient funding for
    continued investment. Money is the ultimate commodity and always should be
    used sparingly. However, it is also the fuel for the growth engine. If the feeding
    requirements are underestimated, the growth and vitality of the venture will be at
    risk
•   Organizational misalignment. The organization best-suited to starting a new
    venture is seldom the best one to run it later on. Initially, the alliance is
    concerned mostly with getting everything up and running, including R&D,
    business support systems, financial systems, and so on. Rollout schedules must
    be met and bugs worked out of information systems, as needed. Functional
    organizational structures are generally best at this stage, with most activities
    focused internally, including many marketing and sales tasks. However, often
    organizational planning doesn’t go much beyond this stage in the business plan,
    placing the alliance at risk of failing to organize itself for the longer term. A
    mostly external focus is then needed, when the organization’s activities revolve
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   around products, markets and customers.

Due diligence reviews of planned alliances require comprehensive, forward-looking
assessments of all aspects. They should be undertaken with as much care as is put into
the business plans themselves. A due diligence review, in fact, should be seen as an
integral and necessary part of the overall planning process, with expected benefits that
will enhance the success of the venture, as well as substantially reduce the risks to
investors and lenders.