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How to Perform Due Diligence on a Private Company

Due diligence—or researching and learning particular facts about a product or private company—is helpful in vetting and validating potential investment targets. Due diligence can transform you from a novice investor to an informed investor, and if you work in investment banking deal sourcing, understanding this process is highly advised. 

While it might seem like a daunting task, the outcome can be highly beneficial. Today, there are even M&A software and tools that can help to simplify the process for private equity investors. The types of facts you could reveal via due diligence may include but are not limited to a company’s reviews, performance, achievements, financial records, press coverage and more.

How to Perform Due Diligence on a Private Company

Here we will discuss how to do due diligence on a private company efficiently, allowing you to acquire essential information that will provide you with a balanced perspective while making investment choices.

A few things to remember as you continue reading:

  • Due diligence is a calculated deep-dive study of a private company in which you may potentially invest. It’s important to gather and confirm all facts before making a decision.  
  • As the old adage notes, knowledge is power, so by performing accurate and thorough due diligence, you’ll be better suited to make a well-educated investment decision that aligns with your goals.
  • Be sure to evaluate a wide range of factors such as the company’s risks, value, revenue, management, competitors, capitalization, et al.

Market Capitalization

Market capitalization, also known as “market cap,” is defined by the total value of all of a company’s shares of stock. You can calculate market capitalization by multiplying the price of a stock by its total number of outstanding shares. 

  • For example: a company with 500,000 shares with each share selling for $100 equals a market cap of $50 million.
  • This market cap figure—versus sales or total assets—can then be used by the investor to ascertain a company’s size.
  • Market cap determines how volatile a stock might be as well as how broad the ownership may reach.
  • Companies with a large market cap often have more stable and less volatile revenue streams. 
  • Companies with mid and small market caps may only serve niche areas of the market which can often lead to volatile stock prices and earnings. 
  • It’s important to remember that the market cap is only a part of the fact gathering of due diligence. It should not affect your decision making process until all the necessary information has been accumulated.
  • It’s also important to note on which stock exchange the shares trade—i.e. New York Stock Exchange, Nasdaq, etc.—or whether the private company is an American depository receipt (ADR) with another listing on a foreign exchange (this is easy to find as ADR will usually be visible somewhere in the title of the share listing).
  • The cumulative information from research will help determine whether you can own shares in your current investment accounts.

Margin Trends and Revenue

When it comes to finances, margin trends, revenue and profit are the ideal place to begin when performing your due diligence on a private company. 

  • Start with researching the revenue and net income trends over the span of two years at a financial news site—preferably a user-friendly one at which you can easily find detailed company information using the company’s name.
  • Legitimate financial news sites offer chronological charts that reveal a company’s price fluctuations over time as well as provide the price-to-sales (P/S) and price-to-earnings (P/E) ratios.
  • Be sure to also note the recent trends in both the P/S and P/E figures and whether the growth is irregular, highly volatile or unvarying.
  • Be aware of whether profit margins are rising, falling or consistent. This information should be available on the company’s website via their investor relations which will show their quarterly and annual financial statements.

Industry and Competition

With the information accumulated in the research of market capitalization and margin trends and revenue, you should have gleaned the company’s size as well as its monetary earnings. 

Now, it is important to understand the industry in which the private business operates as well as its competition. Here are a few considerations to keep in mind when conducting this research: 

  • It is important to fully understand the company’s business model for this research, so be sure you have a strong grasp on the model before continuing.
  • Compare the company with the margins of at least two other competitors. By researching the major competition in each line of the private company’s business, you will have a better perspective on the scale of the product’s end markets.
  • Most major stock research sites will make this information readily available so you can assess the industry and competition within it. The ticker symbols of the company you are investigating as well as its competitors can be found on these sites and will offer direct comparisons of particular metrics.

Valuation Multiples

In this process, you will be performing business due diligence on a stock by studying the price-earnings growth ratio (PEG) for the private company you are investigating as well as its competition. 

  • P/E ratios will often lay down your foundation for reviewing valuations. It is important to remember that even stable companies will often display some volatility in their earnings.
  • Note large discrepancies in valuations between the company and competitors.
  • Basing valuations on trailing earnings or current estimates can act as a way to compare broad market multiples or competition. 
  • From here you will discover whether a company is a growth stock or a value stock, which will give you an idea of the company’s profitability. 
  • During the diligence process, be sure to assess net earnings figures over the span of a few years to ensure the current earnings figure is stable.
  • Remember that the P/E ought to be looked at in correlation with the P/S, price-to-book ratio (P/B), and enterprise multiple. This will reveal important valuations in relation to the company’s debt, annual reviews, and balance sheet.
  • Note that ranges in these values will vary between industries.
  • In conjunction with the PEG ratio, one can determine the expectations for future earnings growth and how that will compare to the current earnings multiple.

Management and Ownership

While performing your private equity due diligence, these questions regarding the company’s management and ownership should also be answered:

  • Is the company currently run by its original founders?
  • Has there been a lot of turnaround and changing of the guard?
  • How old is the company?
  • What kind of professional experience do the top executives and management have? (this can usually be found in the bio section of the company’s website or in its SEC filings)
  • Do founders, executives and managers hold a large proportion of the shares? (high personal ownership by top execs is a pro while low ownership is a potential con)
  • What percentages of the float are held by institutions?
  • How much analyst coverage is the company getting?
  • What factors are influencing the volume of trades?

Finding this information on a company isn’t always the easiest task in the deal sourcing process. However, this search process is now being enhanced by digital tools such as SourceScrub. SourceScrub equips analysts with the tools to easily find this information for private companies, since it scrubs lists and company data for you. 

Balance Sheet Review

To provide a brief definition, a balance sheet is a financial statement that details a company’s assets, liabilities, and shareholders’ equity at a particular time. It essentially offers a glimpse of what the target company you are researching owns and owes and how much has been invested by shareholders.

  • Review the company’s consolidated balance sheet to understand the level of assets and liabilities.
  • Examine the company’s cash levels, its amount of long-term debt, and its ability to pay short-term liabilities. Remember a lot of debt is not always a red flag—this is dependent on the company’s business model.
  • Review the debt-to-equity ratio to see the company’s amount of positive equity and compare with the competitors’ debt-to-equity ratio.
  • Find out why top line balance sheet figures (total assets, total liabilities and stockholders’ equity) may significantly change between years.
  • Quarterly/annual reports can offer some illumination, especially within the footnotes that follow financial statements and management discussions.

Stock Price History

Investigate how long all classes of shares have been trading and the short-term and long-term price shifts. Volatility and stability come into play again here, as this indicates the stockholder’s profit experience and can influence the stock’s future movement. This research will help determine particular risk factors.

Stock Options and Dilutions

Closely examine the 10-Q and 10-K reports which will aid in the understanding of how the share count could shift under various price scenarios. Pay close attention to the details here and be vigilant of suspicious practices.

Expectations and Risks | Putting it All Together

Research what the future consensus revenue and profit estimates are, the long-term trends that may affect the industry, as well as any information about the company’s potential partnerships, mergers, joint-ventures, product/service launches, and intellectual properties. Combine this data with the previous information gathered to look at the greater picture.

Risk and investment go hand-in-hand, however by performing your private equity due diligence, you are able to have the best possible perspective on the inherent risks and opportunities. Be mindful of myriad scenarios, like whether a target company is eco-conscious, if its moral compass aligns with yours, or if it is entrenched in any lawsuits.

Question every detail and remember that you can never have too much information when it comes to mergers and acquisitions.

Sources:

  1. WallStreetMojo. 10K vs 10Q. https://www.wallstreetmojo.com/10k-vs-10q/
  2. The Balance. Using the Price-to-Earnings Ratio as a Quick Way to Value a Stock. https://www.thebalance.com/using-price-to-earnings-356427