Operational due diligence is a unique forward-looking form of due diligence that focuses on prospects rather than past performance. It is an initial assessment of whether or not the company’s operations will generate and maintain value over time.
So, what is this procedure exactly? What does it involve? How can you simplify operational due diligence? We are ready with all the answers!
What is operational due diligence?
Operational due diligence is a type of due diligence that researches a business’s functioning and structure to ensure its compatibility with the prospective buyer’s requirements.
Simply put, the primary purpose parties pursue throughout the process is to answer the question, “What are we going to do with this company when it is ours?“. In more detail, the goals are as follows:
- Evaluate the sustainability of the target’s operations in the future without additional investment beyond business management’s plan.
- Identify actions and investments that can accelerate effective value creation, which the target management team has not considered.
- Advise the deal team regarding the strategic fit of the proposed transaction.
- Gain approval and support from all parties for the planned change.
Pro tip: In-house due diligence is a wise move for the company that is being acquired. Many deals fall through due to problems that surface during due diligence. So, if the sell-side conducts due diligence before the buy-side gets involved, a target can resolve issues swiftly and discreetly.
Operational due diligence and private equity
ODD is a crucial part of private equity and real estate investment due diligence, in addition to M&A. Investment managers and hedge fund administrators should uncover potential operational risks before making recommendations. Although private equity managers often possess significant expertise in investment matters, they may not have enough knowledge of operational functions, such as technology or data security. This gap can lead to losses if ODD is not performed.
To help you better understand the procedure, we have compared it to other types of due diligence in the section below.
Learn more: The importance of operational due diligence in private equity and real estate
What are the main differences between operational due diligence and other due diligence types?
By understanding how this due diligence differs from other procedures, investors can effectively identify and mitigate risks, allocate resources, communicate with other parties, and manage investments post-closing. So, here is a brief comparison for you:
| Operational due diligence | Other types of due diligence (commercial due diligence, financial due diligence, etc.) | |
| Focus | Includes operational aspects of the investment entity, including processes, controls, and operational infrastructure. | Includes specific areas such as financials, legal, market, or technical aspects depending on the type. |
| Objective | Evaluates potential operational risks and ensures proper controls and procedures to protect investors’ capital. | Researches specific aspects relevant to the type of due diligence, such as financial health, legal compliance, market positioning, etc. |
| Stakeholder involvement | Involves parties across various operational functions within the investment entity, including management, operations teams, compliance officers, and service providers. | Involves parties specific to the areas being assessed. |
| Frequency | Typically is conducted periodically or before making significant investments. | Is conducted at specific stages of transactions or projects, such as during mergers and acquisitions, financing rounds, or regulatory compliance assessments. |
The due diligence process hinges on the comprehensive assessment of all relevant aspects of a target. Therefore, we invite you to explore its framework, which is the backbone of the procedure.
What is an operational due diligence framework?
It is a structured set of guidelines used to evaluate the operational aspects of a target company or investment entity. It serves as a roadmap and ultimately contributes to informed decision-making and successful transaction outcomes.
Typically, conducting operational due diligence includes the following:
- Target business model
Essentially, a company’s business model refers to how this company turns inputs into outputs. This distinction is crucial as it directly impacts the company’s attractiveness to investors.
For instance, if a target’s inventory cycle is excessively long, it means that a significant portion of its cash is tied up in inventory for a prolonged period. It can be a concern for a potential investor. As a general rule, the more easily a company can generate cash, the more appealing it is likely to be to investors.
👁️🗨️Potential challenge: Getting comprehensive data on the company’s business model for an ODD review, i.e. a business plan, financial statements, revenue streams, and operational metrics, can take time due to the dispersed nature of the information.
- Human capital
During due diligence, it’s also essential to evaluate the human capital element of the target. In particular, you can do it through HR due diligence. The goal is to examine how much the target company’s workforce contributes to successfully executing its operations.
For example, if a company has seen a significant increase in its sales over the past two years, it’s important to investigate whether this was due to the efforts of a single salesperson or a collective team effort.
👁️🗨️Potential challenge: HR due diligence involves reviewing hundreds of employee-related documents, such as employment contracts, organizational charts, and HR policies. It is usually time-consuming and labor-intensive.
- Long-term assets
The significance of conducting due diligence on a company’s long-term assets increases in proportion to the degree of reliance of its operations on those assets.
However, it would be wrong to presume that the absence of heavy equipment in a company’s inventory implies the insignificance of its long-term assets. In present times, computer hardware is an indispensable aspect of the majority of businesses’ operations.
👁️🗨️Potential challenge: Assessing the value and condition of long-term assets requires organized document management and collaboration among stakeholders.
- Risks and mitigating factors
In any transaction, operational risks are the most significant after financial ones. Therefore, it is vital to ask some key questions to identify and address all possible risks. Some of the most important things to ask are as follows:
- What could stop the target from operating at its current capacity after the transaction?
- Is there anything in the current operations of a target that conflicts with how we operate?
- How have the operations of the target company improved over the past five years?
- Is it possible to quickly and cost-effectively improve the company’s operations in a short period?
You need to consider these important operational due diligence questions to ensure that all relevant risks are reduced.
👁️🗨️Potential challenge: Analyzing operational data and identifying potential risks requires access to comprehensive and up-to-date information from various sources.
Now you know what a robust ODD framework is like and some potential challenges. Soon, we will tell you how to manage difficulties with the help of a modern online solution. But first, look at the ODD checklist for a structured and systematic approach to the procedure.
Operational due diligence checklist
An operational due diligence checklist is a list of items and tasks an investor uses to evaluate various aspects of a target. It may vary based on the transaction specifics and the preferences of the investor conducting the assessment. However, we have prepared the questionnaire and tasks that anyone starting the process can use, which is the following:
- An initial assessment of a target
- How well do a company’s operations fit with a buyer?
- What conflicts are there between a buyer and a target?
- Are there any immediate strategies or actions that can quickly create value?
- What financial investment is necessary to elevate a target company’s operational performance to the desired standard?
- How sustainable are operations?
- Document review
Investors and buyers usually review the documents related to the following:
- Internal procedures
- Company compliance
- Relevant licenses and subscriptions
- Technology underpinning operations
- Intellectual property (if applicable)
- KPIs of a target’s operation against industry competitors
- On-site visit
- Evaluate the company’s current operations overall and determine potential changes if it were to be acquired.
- Evaluate the condition of the factory, office, or logistics center, including technology, equipment, and machinery.
- Conduct interviews with operations managers to gain insights into current practices and challenges.
- Interview relevant stakeholders in the supply chain, such as suppliers, distributors, and service providers, to understand dependencies and potential risks.
- Identify backlogs observed at the company site.
- Evaluate the possibility of implementing planned performance improvement initiatives within the current operational framework.
- Explore the organizational culture. Determine whether the process is structured or ad hoc. Identify decision-making processes and address health and safety concerns during the assessment.
- Projections
- Use gathered information to make projections regarding a target’s potential value added. Check whether it can increase value from existing machinery/technology and evaluate the significance of any extra capacity.
- Work closely with commercial and finance teams to develop a budget tailored to a target company’s operations. Consider factors such as operational costs, investment needs, and opportunities for revenue growth.
- Partner with a finance team to estimate synergies from a merger or acquisition with a company. Analyze potential cost efficiencies, revenue synergies, and strategic advantages arising from the integration of operations.
Now you know what ODD is, how it differs from other procedures, its framework, and a list of questions and tasks. Next, we invite you to explore a secure feature-rich solution designed specifically for data-heavy business transactions with multiple parties. Therefore, it is a perfect fit for the deal.
How can you improve the ODD process with virtual data rooms?
A virtual data room is a secure online platform that simplifies storing and sharing confidential information. It also allows authorized users to collaborate and work safely on data stored within the storage. A significant aspect distinguishing professional services of data room providers from other data-sharing solutions is the high level of document security and ease of use.
Typically, business users employ the software in complex financial deals such as mergers and acquisitions, where due diligence requires the secure sharing and reviewing of confidential information amongst multiple parties.
Here is how the software can help you with ODD:
- Centralized data access
Each person, including investors, advisors, and any other member of a due diligence team, has easy, safe, and simultaneous access to the same information. Regardless of each manager’s location, multiple-party teams can safely collaborate on data.
Key features
- Automatic index numbering
- Bulk data upload
- Full-text search
- Multiple file format support
- Windows Explorer integration
Bulk upload feature ⬇️
- Unparalleled information security
Data rooms offer robust security features to protect sensitive information during ODD. With them, you can prevent unauthorized access and ensure confidentiality, which is crucial when dealing with sensitive business data.
Key features
- Real-time data backup
- Multi-layered data encryption
- Two-factor authentication
- Dynamic watermarking
- User security impersonation
- Remote wipe
- Remote shred
- Easy multiple-party communication
Virtual data rooms enable efficient exchange of questions, comments, and responses. It reduces delays and improves transparency.
Key features
- Q&A module
- Commenting
- Annotations
- Private and group chats
Q&A module feature ⬇️
- Effective user management
Admins can manage dozens of participants on the platform without effort. Data rooms also provide features to control user access on a granular level to ensure that only authorized individuals can access specific information relevant to their role in M&A due diligence.
Key features
- Single and bulk user invitation
- Detailed user permissions
- User group setup
- Instant notifications
Detailed user permissions ⬇️
- Detailed reporting
With data room reports, all transaction parties gain deeper insights into a company’s aspects, identify potential risks and opportunities, and make informed decisions.
Key features
- Full audit trails
- Color-coded reports
- Intuitive activity dashboards
Color-coded report ⬇️
- Ease of use
User-friendly interfaces and intuitive navigation make it easy for participants to access, view, and collaborate on data. Thus, parties get an accelerated ODD process at each stage of the deal lifecycle.
Key features
- Single sign-on
- Scroll-through viewer
- Drag and drop data upload
- Multilingual access
- Mobile apps
- Branding
Branded data rooms create a professional and credible environment for an ODD team. Adding your company logos, color schemes, and branding messages enhances trust among users.
Key features
- Customized watermarking
- Customized interface
- Automatic translation of the data room index
Customized interface ⬇️
Since the functionality of virtual data rooms varies, we have selected the most suitable providers for ODD. This way, you can make an informed decision when choosing a solution for your current and future needs.
Top three virtual data room providers for operational due diligence
We based our selection on provider functionality, service pricing, free trials, and verified ratings.
| Top features | Free trial | Pricing (per month) | Rating (according to Capterra) | |
| iDeals | Automatic index numbering Full-text search with OCR Drag-n-drop and bulk upload Excel viewing permissions 8-level document access permissions User security impersonation Fence view Advanced Q&A Color-coded reports Branding | 30 days | Contact iDeals for details | 4.8 |
| Ansarada | Data backup Scroll-through file viewer Access expiration Web-based spreadsheets viewer Q&A module New document email notifications Custom login page | 14 days | $399 – $2,351 | 4.6 |
| Datasite | Data backup Two-factor authentication Web-based spreadsheets viewer Document version control View-only access Remote shred Real-time audit trails Q&A module Custom workflows and features | 14 days | Contact Datasite for details | 4.6 |
Visit each provider’s official website to research them more thoroughly. Also, read reviews from other users since they could impact your choice. It will help you make an informed decision that best serves your goals.
Conclusion
Managing ODD can be challenging when dealing with large amounts of data and multiple participants. Therefore, it is vital to employ a solution that can streamline the procedure.
Luckily, today’s business tech industry offers the best practices! Virtual data rooms provide a feature-rich platform specifically designed to meet the needs of ODD. So, choose your tool and make this complex procedure a breeze!