How to Perform Due Diligence on a Private Company

Private Equity
Venture Capital
Last updated:
June 14, 2022

From starting a new job to purchasing a new home, the process of extending, negotiating, and accepting offers is exciting. For investment bankers or private equity firms, getting a "yes" after all the hard work required to complete an acquisition agreement feels incredible. But as much work as it is to get to the point where an offer is accepted, there's usually more work ahead.

For new jobs, it's all about fitting in with your colleagues and proving yourself within the first 90 days. For housing, it's moving everything you own into boxes and transporting them from one place to another. In mergers and acquisitions, an accepted offer means the due diligence process is next in the M&A pipeline. So what does due diligence entail? Let's dive into how to perform due diligence on a private company.

How to Perform Due Diligence on a Company

Due diligence refers to collecting and then analyzing data from your target company to find any potential issues, ensure the deal is sound, and certify that it's the right move for both companies. To adequately perform due diligence, you'll need many types of data, much of which is confidential and must be provided by the company itself. 

Firms that take a data-driven approach to deal sourcing can save themselves a lot of time and headache in the due diligence stage. Although fresh, accurate data can be difficult to find for private or bootstrapped companies, using a private company intelligence platform like SourceScrub enables firms to identify and pursue opportunities with the highest probability of making it through the due diligence process.  

Doing your homework on a private company you intend to acquire or merge with usually requires a three-step investigation.

Step 1: Financial Performance

The first step of any due diligence process is to assess financial statements such as quarterly or annual reports. Because you are performing due diligence on a private company, you cannot rely on stock information as you would if your firm were acquiring a public company. Instead, you will need to do a deep dive to analyze the performance of the business and do your financial due diligence.

Revenue and Trends

Private companies will sometimes publish public revenue information, especially as they cross certain milestones ($100M ARR, for instance). You should have already found out the publicly-available information — estimations are also usually available through certain data sources — but now you can ask your target company for specifics.

Some examples of standard financial documents are:

  • Balance sheet figures
  • Income statement
  • Profit margins
  • Margin trends
  • Income trends

Make sure to get at least a few years' worth of records (if possible) and carefully analyze them to determine how the business has been doing. Be aware of any audits and their results. Remember, the due diligence process is about protecting your firm and evaluating the deal's validity. You should be on the lookout for anything that doesn't seem quite right.

Part of evaluating the financial aspects of the business is to look at where money is being spent (and gained), as well as any fluctuations over time. What does the burn rate look like? How much money is being spent in each department? Do the projections seem realistic? Now that you have the confidential financial statements, you can answer many more questions about the company's viability than you could before. Use that information to ensure they still fit within your firm's portfolio and make sense as an acquisition target.

By the end of your review, you should have knowledge of at least the following:

  • Total assets and liabilities
  • Long-term debt levels, as well as the company's ability to pay short-term debts
  • The debt-to-equity ratio

Equity and Stock Options

Depending on if the target company has gone through funding rounds and if it offers stock options as an incentive to employees, you may have a large amount of money you'll need to pay upon the acquisition's close. Getting accurate records on how many outstanding shares there are, plus what the buyout structure includes, should be a key consideration.

Step 2: Market Structure and Composition

The second step in how to perform due diligence on a private company is analyzing the market. Ideally, your firm will have done extensive market mapping prior to engaging with a target company, and is already well-aware of sector dynamics at this point in the deal flow process. 

This step is more about ensuring that your previous research, along with your new knowledge of exact financials, matches your target company’s claims and beliefs. A misalignment here can mean larger problems with the deal are lurking under the surface.

Industry and Competitors

To adequately determine the potential of your target company (and your potential return on investment), you need to understand where it exists in the market. Who are its competitors? Are there any promising future add-on candidates?

Again, much of this information should have already been researched, but now you can see what your intended acquisition believes is its place in the industry and how it views its most important competitors. Go-to-market teams can also give insights on their customer win rates against competitors in the industry.

Market Capitalization and Valuations

Even though your company or firm is buying a private company, it's likely there are others in the market that are public. Not sure how to calculate the market cap of a private company? By doing some simple arithmetic, you can determine the market capitalization of similar companies in the industry. Market capitalization, or "market cap," is found by simply multiplying the price of a stock by its total number of outstanding shares (e.g. 500,000 shares at $100 = $50 million market cap).

Similarly, if any competitors have secured rounds of funding where the price was disclosed, you can often determine their valuations. Be careful here, though: while market caps and valuations should be considered, they’re not a guarantee your intended acquisition is similarly valued.

Finally, check for any other acquisitions that have recently happened in the industry. Again, the purchase price may not be publicly available, but it should at least be on your list of due diligence questions to answer and can help you with your private company valuation.

Step 3: Personnel Information

As with the other steps,you should already have a solid baseline of information about the employees at the target company. From how long management has been at the company to open job postings, your private company intelligence platform should have plenty of insights into the company's cultural health.

However, now that you have more access to data in the due diligence process, you can do a deeper analysis:

  • Employment contracts, including any existing non-disclosure or non-solicitation agreements
  • HR policies, including both health benefits and employee benefits (e.g. unlimited PTO policy)
  • Employee complaints and issues, including any pending legal cases
  • Employee culture (beyond any listed benefits)
  • Historical employee turnover rates

Putting it all Together

Understanding how to perform due diligence on a private company requires firms to embrace the idea that risk and investment go hand-in-hand. But by performing your private equity due diligence, you can have the best possible perspective on both the 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. 

Start yourself on the right foot by embracing direct, data-driven deal sourcing strategies — learn more when you download this free five-step playbook on taking control of your deal flow.

Similar articles you might be interested in