Due Diligence: How to get the best price from Tupelo

‍Why We Wrote This

Most Private Equity people have been trained to treat diligence as an interrogation: we push, you defend, everyone keeps their cards close and paints the rosiest picture of the truth.

It’s not malicious but it’s negative and combative - which rarely leads to the best result for either party. It’s designed to get the best price today, as opposed to the best outcome tomorrow.

We think about diligence differently. We seek to make our process more positive and courteous - befitting of the relationship we hope to build with management teams.

That means a process that’s transparent in intent, respectful of time and information, and anchored around shared opportunity. A process designed to quickly ascertain if there’s a good deal to do, and leave some benefit even if there isn’t.

The process relies on mutual transparency and trust - both things you’ve got to give in order to get.

So, in the interest of starting our relationship on the right foot, we’ve written this memo to make our diligence process clear, transparent and, hopefully, a bit more human.

What we invest in

Our diligence process is a function of our investment strategy, so it’s worth us starting with what we’re looking for to make sense of how we look for it.

We invest in good businesses that would do fine without us.

In most cases, the owners we meet don’t need an immediate buyer - but they’ve got an eye on exit and want someone to help make that 2-3x bigger than it might be today.

The biggest determinant of that is typically size: larger companies attract larger multiples. The assumption here is they have more staying power - a larger, less concentrated customer base, diversified sources of income and well established brand that can weather shocks well.

The second largest determinant is scalability. Small organisations tend to run on a few key people and in-my-head knowledge that poses a risks and restrictions for would-be buyers.

So, to get a bigger sale in the mid-market, you need to get bigger and more scalable.

Those two things are the reason we focus on (1) customer-led growth (sales, product, marketing), and (2) improving operations with technology.

The companies we invest in usually have parts of the story in place, but gaps in others: a small but solid customer franchise, informal but effective processes, competitive but unclearly communicated market positioning. They might have invested in technology but ultimately ended adding more to their expenses than their productivity.

We expect - in fact, want - to see the flaws and failings because fixing them is a big part of our upside. If things were perfect we probably wouldn’t be having this conversation.

That means in our investments we’re looking for two things - potential and problems: does this company have some magic that we can build on, and does it have some fixable problems that we (and, ideally especially we) can solve?

Deal structure

How big this potential and these problems need to be is a function of deal structure.

We are a Private Equity buyer. This means three things:

First, we price off the bottom (profit) not the top (revenue). We’re hoping for growth, but planning for little - so the amount of cash your business generates today is worth more to us than potential but hypothetical growth tomorrow. For ex-VC companies, this can be a bit of a sharp correction in valuation expectations. More on pricing later.

Second, we have a +3x target return inside of 5 years. That’s the return we underwrite to after we’ve stressed and discounted management’s business plan. Our return profile is much less volatile than venture - we dont need or expect you to be a unicorn but we also don’t take the risk on the business going to zero.

Stake

Finally and probably most contentiously - we acquire much larger stakes.

We typically write deals where we take a majority stake, and the existing owners retain a minority holding, I.e.  they roll their equity alongside ours. There are two reasons for that.

First, alignment.

You know your business better than we ever will. You’ve turned moats and a little customer magic into something successful — it’s on that basis that we invest.

Backing a transition to a brand-new owner is risky and rarely our model. We’d rather work with the people who made it work in the first place. So we want to keep you involved and incentivised to keep pushing higher.

That said, we also recognise that most owners want to take some money off the table — pay off the mortgage, put the kids through school, enjoy some of what they’ve built.

So our deals usually balance some cash-out for founders/owners whilst keeping enough skin in the game to make the next leg of growth meaningful. You de-risk personally but stay invested in the upside you’re helping to create.

Second, assurance.

We have our own investors — they back our deals because we make a case that the businesses we invest in can grow.

That case is built on a specific plan and a set of targets, and our investors expect us to be able to deliver against them.

So we need a level of control that gives us confidence the agreed plan will actually be executed. That’s why we do more of the planning up front than most private-equity firms — so both we and you are clear on the strategy, priorities, and first steps before we invest.

It doesn’t mean the plan can’t change — few survive first contact with a customer — but we need to be sure any change makes the business stronger, not weaker. That’s part of being a responsible steward of our investors’ capital as well as your business.

Fees

We have two principals on fees: (1) we don’t get rich on fees, and (2) we don’t charge rent on investors idle money.

We get paid for the work we do. That means safely organising the deal and putting a shoulder in to help make the company more valuable.

Our fees break down thus -

Transaction fees are covered by the business. This is covers the cost of verifying your financial, operational and legal standing and ensuring the investment is executed soundly. We hold all fees until a Letter of Intent (LOI) is assigned establishing a deal structure and terms on which we can base any diligence activity.

Management fees are charged annually to the company. For some investors - this would be an expensive board fee, but our model deploys highly experienced operators directly into your team; you tend to get a better deal than hiring/contracting equivalent skills in the market.

We’ve also found Management Fees to be a strong forcing function. They force both you and us to consider if we’re the right investor - “do we provide value for money, and would we spend time away from our kids on this business?”

Who takes this deal?

So if you sell most of your company, don’t get to retire and get to pay annually for the privilege - you might ask, “Who takes a Tupelo deal?”

Not everyone.

But usually it’s an owner who’s had success, but not as much as they know is possible — someone looking for a partner to help take the business into the next category up.

That ambition gives our deals a very clear checksum - the cash you take now, and the holding you have left needs to be worth more than your current stake would be if we didn’t invest at all.

The calculus varies, but that typically means working to grow the value of your business by >3.0x over a 4-5 year period (convenient, eh?).

So, taking these two points together it’s clear we need to find potential and problems that will allow us to at least 2-4x the value of your business. Our chosen - but not exclusive - weapons are growing your customer franchise and using technology to make the machine run smoother and scale easily. Establishing if there’s a deal to be done with your company is the role of diligence.

Diligence

Diligence is about making sure we see the same reality — where you are, where you could go, and what’s standing in the way. For us, diligence has three core functions that help ensure a good outcome for all parties involved.

Protecting the downside

Some diligence has to be about fraud prevention — checking that what’s presented stacks up.

Bad actors do exist, as do hidden risks - and protecting our investors from both is what makes us good stewards of their money.

So yes, whilst we enter negotiations in good faith, forgive us for double- or triple-checking the details: “trust, but verify.”

But diligence for us is just as much about gathering evidence for growth as it is about verifying how the business performs today.

Understanding the risks

We’re not looking for perfection. In fact, if everything looks perfect, we’ll assume we’ve missed something.

If everything appears rosy then there’s usually two reasons for that: (1) you’re in the wrong place, and there’s tons of growth investors who’ll write you a better cheque on better terms (we will introduce you to some if that’s the case), or (2) you’re selling us a manicured version of the truth. Either way, there’s no deal to be done and we can all move on with time to spare.

We want to understand what’s already strong, what’s holding you back, and what can be fixed or built upon - because that’s where the returns come from.

Imagine and scrutinise the upside

Getting a good grasp on the risks and issues is one thing - doing something about it is another. A lot of PE firms will stop here, come up with some sensible sounding plans in sensible looking spreadsheets, hand those to management and ask them to deliver it. We started our careers at Accenture - one of the biggest and best delivery companies on the planet - so we’ve been handed a fair few of these decks, and seen the infeasibility, impracticality and often incoherence of some of these plans.

So, in lieu of making some rather expensive assumptions, we go and - you, know - ‘check’ first. In our strategy that means spending a lot of time with two people - your customer and your employees.

We want to talk to the people who are actually buying and using your product as they’re the ones with the biggest say in whether they, or people like them, buy more of it.

Similarly we want to spend time with people who make the business work - hearing about what they enjoy, what frustrates them and why they turn up to work in the first place - so we’ve got a chance of building and changing things that actually add to their capacity, not just to the technology budget.

In our view, we should be checking ‘the facts’ about what customers and employees believe and do as much as the financials and legal fine print.

In any diligence we’d expext to spend time with at least 15-30 customers, and a week or so with employees.

When done well, the whole process feels a bit more like a strategy consulting project: we take a cold hard look at where you are today, how that stacks up against the market and where the opportunities exist for growth, improvement and increasing your valuation. This one doesn’t try and sell the next phase of work - it’s a clear eyed view of what’s good, what’s not, what can be done, how achievable it is, and whether we would or should have an impact on it. Refreshing, I know.

We realise providing access to your employees and customers is an extra level of effort and risk - which is why we commit to sharing our analysis with you at the conclusion of the process. Best case, you’ve got a deal - worst case, you’ve learned something about your market, competitors, or customer - and gained a cheat sheet to how the next investor might review your business.

How to get a the best price

This is the bit you’ve probably scrolled to first. There are three main factors that go into this.

The first you have no control over - the market. The market determines the multiple range - the highest and lowest price investors are willing to pay for company equity in your sector (as a function of trailing earnings).

The second you have a bit of control over: quality. This sets where you sit in the range. Good growth, high retention, efficient operations all count. The quantitative side is kind of set - how you’ve performed previously and how your performing now are somewhat fixed. The qualitative side does make difference - what are your team like on calls, how fast do they respond, how clear and structured is the data behind their responses - all are endemic of a top-range company.

The third you have complete control over - risk. More accurately - transparency on risk. Ultimately we need to price on risk - if we’re confident we’ve understood the risks and issues, and have sound mitigations in place then we can price at value; if we feel uncertain then we price to protect ourselves to the downside. Being transparent with us on your flaws, the risks you face and the challenges you see has a very real impact on the valuation of your business. It’s the easiest thing companies can do in a process - but is the one most overlooked in favour of any “sunny uplands” story that we all know doesn’t stack up.

In summary, we’ll pay for quality and we’ll pay more for confidence — for knowing what we’re dealing with and how we can improve it.

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