Nathan Sykes

March 19, 2021

Trust Based Due Diligence Rocks

One of the most boring parts (in my opinion) of working in private equity is due diligence. If you're not 'hip' to the PE 'jive', due diligence is when you confirm the value of a company you're looking to acquire by verifying their financials, growth, payroll, customer base, cash flow, credit lines, assets, liabilities, etc.

Public securities have it easy - all you've got to do to conduct basic due diligence is look at their SEC filings, and you'll have a boatload of information on whether or not the company is a sound investment. With private equity, things are a little bit different. You need to intentionally seek all of this information out.

Now normally, a broker or an agent who specializes in private equity transactions can handle all of this for you. But with a firm like Howdy Interactive, where our deal size is $250,000 USD or less, it doesn't make a lot of sense to retain an outside firm to assist with this process, as their fees would balloon the upfront capital we're investing to make a deal happen (we calculate all of our closing fees in our upfront invested capital calculations, some PE firms don't. Personal preference, I guess!)

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Even if we do all of our due diligence in-house, doing so on the roughly 250 inquiries we receive each year would put us out of business in manpower costs alone. We need to pick and choose, and to do so, we employ something called 'trust based due diligence'.

Trust based due diligence isn't a financial process, it's a relationship process. When we receive a new inquiry from a founder looking to sell their micro-company to Howdy Interactive, we immediately hop on a Zoom call as soon as our schedules align. On their end is the founder, or maybe founders if there's more than one, and on my end is myself and my assistant. My assistant doesn't speak at all - they're just looking at the other party, mapping their body language, the words they use, and the way they speak. The meeting is recorded and stored on our secure servers in a folder we've created for the founder's inquiry in our head office Basecamp.

After I answer any questions about how selling to a micro private equity firm works, I start with a quickfire round of questions about their business model, financials, profitability, liabilities, growth, platform, etc. I don't anticipate them knowing the answers to most of what I'm going to ask, but that's not why I'm asking. What we're trying to discern is whether founders are comfortable misrepresenting facts and statistics to glaze over the fact that they're not prepared to answer those questions, or to truthfully answer "you know what, I'm not exactly sure, but to the best of my recollection..." when asked. There's a difference between the two, and it's easy to spot. We don't like to do business with people who are fundamentally deceptive, and that's what that tells us about them.

If we like what we hear on that initial call, we'll send over a non-binding letter of intent and due diligence agreement, which gives us access to their financials (straight from the source, like Quickbooks, Square, or Stripe), and growth tools, if they have any. That's all we ask for right now. We then make sure that the numbers they gave us during the interview match up with the actual numbers we're seeing in due diligence. If they do, excellent! If the founder truthfully didn't remember a fact or figure, that's fine too. But if something's way off target, that's a problem, and we end due diligence right then and there.