Before an investor buys a company, there is usually an extensive sales process. As part of this process, the investor puts the target company through its paces in what is known as “due diligence”. In addition to the assessment of the financial and legal situation, “commercial due diligence” is of central importance. This examines the extent to which the company has established a sustainable position in the market and what growth potential exists for the future.
As an analyst at FLEX Capital, I have researched and evaluated several hundred companies and markets over the past two years. In the area of “commercial due diligence”, a number of focal points and benchmark indicators have emerged that are of primary interest to investors. This blog post is thus of particular interest to entrepreneurs who are considering selling a business in the future.
Commercial Due Diligence – the checklist from an investor’s point of view
Market
- How is the market defined in which the target company operates?
- How large is this and what development can be forecast for it in terms of volume and prices?
- Which trends are influencing market development – is a disruption possibly imminent?
In the section on the market, the focus is not on the target company per se, but on the entire “playing field” on which it operates. Of great importance for investors here is the question of the maturity of the market: Can we assume further growth (“blue ocean”) or are existing competitors fighting for shares of a constant piece of the pie (“red ocean”)?
Competition
- How is the competitive landscape structured in the market?
- Along which characteristics do the existing competitors differentiate themselves?
- What dynamics, for example takeovers and consolidation, can be observed along the value chain?
In the analysis of competition, the focus is on the one hand on the “macro view”, i.e. how many competitors exist and on what scale. Niche markets are often served by a few specialized suppliers, whereas the supplier landscape in mass markets is made up of a few large firms and a very long tail of small firms. The second is the “micro view,” in which competitors are compared and contrasted with the target company on the basis of specific criteria such as price, product features and customer satisfaction.
Target company
- What growth has the company been able to achieve in the past?
- What contributions to sales and profit do the various products make?
- What is the company’s organizational structure?
In considering the target company, the initial focus is on historical growth and the associated products. Especially for software companies, the classification of revenue by origin (licenses, maintenance and implementation) is also common.
To get an idea of whether the company is growing profitably, it is a good idea to use the “rule of 40”. The percentage sales growth and the EBITDA margin are added together. If the value is above 40%, the company has achieved a very good mix of growth and profitability. For already established companies, however, the value “40” is rather high. Lower values should therefore not be regarded as a general criterion for exclusion.
The organizational structure of the target company is also important – which tasks are still the responsibility of the founding team and which have already been delegated to a second management line?
Customers and buying behavior in commercial due diligence
- What is the customer structure of the target company?
- How many new customers are usually acquired and how many are lost?
- Which factors significantly influence the purchase decision?
In the section on customers, the first task is to understand possible dependencies on major customers. Customer concentration is usually used as a measure for this, for example, what percentage of sales is generated with the largest five customers.
Further analyses then deal with movements in the customer structure. Of particular interest to investors in the software sector is the “churn”, i.e. how many customers the target company loses due to termination by customers. Non-financial key figures, such as the development of the “churn rate” of customers, are of particular interest. They provide direct information on how sales will develop in the future and whether the product has certain unique selling points. Often, this also allows conclusions to be drawn about how business-critical the product is for the customer. What “churn-rate” is acceptable for a company depends very much on what products it offers and what growth phase and industry it is in. It therefore makes no sense to look at the “churn rate” on the basis of a number, detached from the company and products.
Business plan, value levers and risks
- What growth is management planning and how realistic are the underlying assumptions?
- What could further value levers of an organic and inorganic nature look like, for example acquisitions?
- What are the fundamental risks involved in investing in the target company and how can they be countered?
After the previous sections have dealt mainly with the current situation, the question of the future development potential of the target company is now addressed. First, the business plan prepared by the management of the target company is reviewed for its achievability. The historical development of the company (see chapter Target company) often provides good indications for this. Investors also look at additional strategic options at this point, analyzing, for example, whether potential acquisitions can be synergized product-wise, complementarily and financially. The chapter is often rounded off with a summary of the major risks found in the previous chapters.
What does this mean for entrepreneurs?
In the hustle and bustle of day-to-day business, entrepreneurs often find it difficult to take a strategic look at their company from a bird’s eye view. Even if no sale is imminent, entrepreneurs can use the core analyses of the “commercial due diligence” to gain visibility on the strategic positioning of their company along a “checklist”.
Entrepreneurs who, on the other hand, are planning to sell their company in the medium term should consider at an early stage how an investor will assess their company in the course of “commercial due diligence”. Even if the targeted date of the company sale is still somewhat distant, it may be worthwhile to obtain an independent opinion directly from the investor side. Often, issues are identified together during the conversation that can then be addressed before a sale is made.
