The Art of Good Due Diligence
Over the years, my understanding of due diligence has changed, moving from a simple check list to a strategic evaluation. When I was in college, I read a newsletter created by real estate guru Mark O. Haroldsen where he pointed out that he made his money researching the deal, not the deal itself. He pointed out that his careful due diligence of apartment buildings would often uncover either opportunity or potential problems. While I had a simplistic view of what he was talking about, I got the basic concept, and it stuck.
Fast forward four decades later, and my due diligence check list is about three hundred points of consideration and growing. Look at enough companies and you begin to get a feel for the business and where to look, but too often it’s easy to overlook some small detail that leads to a bigger fact, that shifts your understanding of what’s going on.
We at Middlerock were brought in to look at a company on behalf of a potential buyer. I had an immediate negative reaction to the seller. Keep in mind, when someone is selling their company or raising money, that first pitch is the very best you’re going to ever hear about the company. Everything that comes after is going to be worse, so if you’re not hooked, it’s probably not going to get better with more discussion. It will almost always get worse so if the vibes are bad, get ready for some repugnancy.
A giant red flag for me is when someone is constantly telling me how smart they are. Smart people never have to tell you. It’s in their results. When I hear it a lot, I think why is this important? What is the overcompensation all about? It causes me to raise my caution flag to danger. In this case, the seller kept talking about how brilliant he was in a nearly empty office with lots of blame about what happened to his company and why, and not one explanation made sense. The overuse of big words also tells mere there are lots of negative bad words we all use behind it.
We wanted to talk to former employees and were given a list of what they said was the “complete list” of employees from the company records. The list seemed unusually small given the size of the offices. We decided to hire someone to help us with our research about prior employees. We conducted a search on LinkedIn of every former employee, their start day, their end day, and we noticed something peculiar. We noticed groups of people who were hired around the same time who all left in the same week who were not on the former employee list. We found these distinct blocks of employees so we contacted a few to ask what happened. They told us that the technology didn’t work and that they were fired when it failed. They also shared other problems that were not disclosed by the seller. We presented our findings to the buyer and he backed out of the deal, saving him millions.
Careful due diligence is an art, and it should look like good old fashioned detective work. Don’t just rely on what someone tells you, dig deeper. In the case of Theranos, that massive sum of venture capital evaporated when investors failed to do their own deep dive, all while relying on the statements of others. Each person pointed to someone else, and the truth was, no real due diligence had ever been thoroughly conducted at any point, from the day the venture first kicked off. In fact, a leading expert at Stanford familiar with the technology said it couldn’t work as a matter of basic physics yet nobody took her seriously.
I overlooked much of my normal due diligence process when I acquired Open Interface North America. I did it because I believed in the engineering team in spite of the condition of the company. I’d been working with them almost a full year, and I was impressed by how they thought about their work and their interactions as a team. That was the only time I’ve overlooked a typical process. Besides, I had an alternate plan for the team if the company mission failed.
When we get a call for help from a CEO, often they waited too long, in part because of embarrassment, and fear that we will be judgmental of their predicament. It’s not how we think. We’re immediately working on a corrective action plan and multiple solutions rather than blame. We know that time is critical, but it all comes down to the right diagnosis of the problem. As Dr. Phil said, if you misdiagnose a patient, you mistreat, and if you mistreat, you not only fail to find a cure, you also harm the patient. Getting that right diagnosis is a part of the due diligence process and where we focus our energy with new clients and why we dig so deep. Nothing is off the table and we’re not there to prove one idea. We have to avoid the “law of the instrument” or the principle of Maslow’s Hammer, and look at all matters from a pragmatic and cross referenced point of view. In the end, we’re looking for the best solutions.
The very purpose of due diligence is to uncover the true situation of a company, good or bad. It’s our job at Middlerock to be pragmatic in how we go about our work so we get to the best possible decision. Yet, the central point I’m making is to take the process seriously, go past what you think is “good enough” and keep digging. You’re likely to find that one answer that will make all the difference one way or another.