A complete guide to commercial due diligence
Introduction
Commercial due diligence is a critical part of buying or investing in a company. For a deal to take place, a seller must be able to satisfy their prospective buyer that the business is sound, customers are happy and the company can continue to grow.
This guide is intended as a primer for owners and investors alike. We’ll cover what goes into a commercial diligence at different stages of a company’s growth, the different warning signs for investors and owners, and the key factors in any successful due diligence audit.
In this article I’ll also draw on my own personal experience. Having sat on both sides of the equation – as entrepreneur and advisor – the experience is quite different for each party. What is often a dispassionate exercise for the investor can feel intensely personal to a founder.
What is Commercial Due Diligence (and Why Does it Matter)?
Commercial due diligence is a process investors and businesses go through whenever one party is investing into another, or buying the other out completely. Broadly speaking, it covers the company structure and composition, legal background, products and services, business plan, sales and marketing, and competitive landscape. A buyer is looking to satisfy themselves that the company represents an attractive commercial opportunity, and identify any potential issues that could prove harmful down the line.
From an investor or buyer perspective, commercial due diligence is clearly incredibly important. Without it, there’s always the risk of unknown or undisclosed problems coming to light once a deal is done. Given the sums of money involved – anywhere from hundreds of thousands to billions of dollars – any investor will want to have their eyes wide open to any threats that may materialize and harm their investment.
As a founder, it can be a disconcerting and very time consuming experience to go through a diligence. Understandably, given the risk investors expose themselves to, they want to kick over all the rocks in the business. A data room will need to be created, and the list of documents required to be shared with investors can be extensive. This list invariably grows as the diligence proceeds.
In my time as a founder, I have experienced both the positives and negatives of this process. In my experience, and that of my friends, light touch investors can be a welcome change when you’re trying to raise a round and grow a business simultaneously. However, despite the additional workload, investors that ask for more information tend to have better follow through to deal completion.
It all starts with a hypothesis
Any investment begins with an investment thesis – a reason for acquiring or investing into a particular company based on what the investor feels they can do to grow the business over the course of the next 3-5 years. While there is sometimes a negative perception around acquisitions and investors’ reputations for stripping assets or otherwise aggressively ‘pruning’ a business, the reality is that any acquisition is fundamentally aspirational in nature.
Investors will start to look at an acquisition through a clear eyed but optimistic mindset that tries to find a great business and makes it better. Consequently, the commercial diligence is a critical activity that looks to confirm or disprove the original investment thesis. For the founder, a successful due diligence will lead to securing either investment or an exit. For the investor, the more conclusively they can prove their investment thesis to be sound, the more confident they will be of the value they can bring and their eventual returns when they sell the business on. That’s why investors are often ready to pay significant sums before the deal to the ‘Big4’, ‘MBB’, and others for a specialist due diligence investigation service.
What’s on a typical commercial due diligence checklist?
It’s important to understand that there’s no one-size-fits-all diligence checklist. Investor requirements change depending on the investor, their perception or confidence in the business itself, and the stage of the deal.
However, there are some broad categories of commercial operations that any investor is going to want to satisfy themselves on:
Market size and opportunity
Market sizing is a core component of the early diligence process. Investors and owners alike do this exercise to try to quantify the scale of opportunity available to them. Acronyms abound in the research space, and sizing is no exception. The standard terms here are ‘Total Addressable Market’, ‘Total Obtainable Market’ and ‘Total Serviceable Market’.
Total Addressable Market
This is the big one – the size of the overall market you’re engaged in and that’s appropriate for the product or service you sell. For example, if you produce small business accounting software, your total addressable market may be the sum of all businesses with under 200 employees in the US and Northern Europe, and the accounting firms that serve them.
Total Serviceable Market
This is typically a geographic consideration, that looks to reduce the total pot of potential customers down to the volume that you can realistically serve with the sales and marketing resources you have, and any geographic, logistical, supply chain, or licensing restrictions that may impact your ability to compete in a specific location.
Total Obtainable Market
It’s often sensible to wrap ‘Total Serviceable Market’ up in this, as by definition if you can’t service a client base, they are effectively unobtainable. This is the proportion of the ‘Total Addressable Market’ that you realistically feel you can capture when you have product/market fit. This may factor in market penetration by existing competitors, the threat of new competitors, current market conditions, the long term viability of the opportunity, or demand for your product or service among specific niche potential buyers.
The ‘Total Obtainable Market’ is quite a nuanced calculation – more art than science in many cases. It requires having a nose for marketing, and a sense of the friction points a product or service is likely to encounter among prospective customers. For a new entrant, it’s a rule of thumb that you should offer a ‘10X’ improvement if you’re to beat the status quo, assuming your product or service is an iteration rather than an innovation. Marginal improvement is hard to sell.
This image from SimilarWeb shows these different concepts in concentric circles of decreasing size.
Customer and competitor assessment
Performing a detailed market sizing naturally leads to more specific questions around competition for the obtainable audience and how that obtainable audience perceives you and your competitors.
This generally ends up being a mix of desktop research and customer interviews. With the advent of easy to implement programmatic research, it is possible to gain a comprehensive insight into the positioning of the target company and its competitors very quickly, using a combination of web scraping and semantic analysis. Review sites, comment sections, customer service CRMs and social media can offer a wealth of easily collatable data that can give a clear basis of truth for market perception of both the target business and its competitors.
This can then be sanity checked using in depth voice of the customer interviews to introduce more nuance and spotlight any customer perceptions of either the target or its competitors that the desktop research failed to unearth.
This happens more than might be imagined. It’s a principle of sales that people tend to make purchases emotionally (even in B2B), and then use logic to justify those decisions. Consequently, by the time many reviews are left, the real hook that caught a customer’s attention or differentiated the target from its competition is left out of the comment. Capturing this ‘emotional’ information is an extremely important part of understanding what’s working and what isn’t in a company’s marketing work – and in understanding whether the demand drivers for a product or service are timeless or temporary.
Occasionally an investor will do some diligence on a specific operational issue in the target company, to understand if it’s also an issue being faced by the competition. I have personally conducted a number of investigations for private equity clients to understand if client churn or employee churn was replicated across a target’s immediate competitors. This type of commercial perspective gives a feel for the competitive dynamics, and how entrenched an operational issue may be.
Sales and marketing assessment
A natural accompaniment to customer and competitor research is a thorough assessment of the sales and marketing plan of the target company. This is a key area any investor would look to add value and improve performance. Ultimately, increasing revenue, whether through acquisitions or organic growth, will have the most significant effect on the return multiple an investor gets from their investment. It stands to reason that founders should expect to have compelling answers to questions around this critical function.
Very often, persistent themes come through from voice of customer calls and customer experience analysis that highlight a lack of alignment between a company’s marketing department and the customers’ real demands from the company.
Below is a Wordcloud generated using Python’s awesome Natural Language Toolkit module, that shows the frequency of concerns highlighted by customers as part of a recent engagement we did for a leading PE firm. This was a small survey/VoC exercise that looked at 2,500 existing customers, competitor customers, and potential customers to understand their impression of an acquisition and the space they operated in. It’s clear from the words that have the highest frequency among the responses that there are a couple of significant barriers to making sales in this vertical – perceived pain of treatment and perception of cost vs value.
The opportunity to take insights garnered during the diligence process and bring them to future sales and marketing efforts is one most investors avail themselves of. In the case of the customer in the engagement cited above, there is significant scope to better address customers’ concerns through their marketing, as a ‘features and benefits’ style of messaging is currently in place, that only tangentially addresses customers’ major reservations.
Sales and marketing technology is another area where investors can look to make a substantial difference. We worked a few months ago with a private equity firm in Atlanta to help move an acquisition in the healthcare space from an Excel-based CRM to Salesforce, and built a webscraping system for the portfolio company to automatically track new opportunities for their platform across the web, and pipe this directly into the CRM using the Salesforce API.
This kind of technical and operational efficiency enhancement is typical, in our experience, of the type of support good investors bring to their portfolio companies. The system above freed up hours of time daily, per salesperson, that has been spent on activities that more directly increase revenue.
Business plan and operating model assessment
As a part of any diligence, an investor will also look at the business plan and operating model of any potential acquisition. This is done to assess the management team’s vision for the direction of the company, how they structure the company to fulfil that vision, and their roadmap for reaching that vision.
This could range from new product and service lines, acquisition targets for inorganic growth, new geographies, new approaches for sales and marketing, a hiring schedule, and any other of a number of progressive ideas.
Investors will also look to understand the assumptions and decisions that underpin how a company got to where it is today. Again, this covers many of the areas above, as well as things like current market positioning, efficiencies vs other competitors in the space, and pricing.
For example, as part of a recent engagement, we conducted a pricing benchmarking analysis on behalf of one of the worlds largest private equity firms. Working with a portfolio company of theirs, with over 450 locations in the US, we conducted a comprehensive competitive intelligence assessment to understand at a granular level the competitiveness of the company’s offering in the markets it served – right down to individual product lines.
Other sources
A brief word on other sources investors look at. The list is almost endless, but SEC or equivalent filings, 10ks and 10qs, RFIs and RFPs as well as expert network sites and other paid sources are all within the standard repertoire of an investor conducting diligence. Investors may even look at analogue markets to try to draw meaningful parallels and predict future outcomes for an investment.
For a particular investor client of ours, they spent so much time mining 10ks and 10qs manually, and compiling data into spreadsheets, that we built an automatic system that scraped the filings programmatically and provided an automatic pipeline of 10k and 10q data.
Costs
An effective due diligence audit carries with it significant costs for the investor. Before considering fees paid to a due diligence investigative service like ours, it’s important to recognise the amount of time an investment team will put into a deal. These are smart, competent, well paid people who spend months in the case of a likely acquisition to really understand a company in enormous detail. Even deals that do not go ahead, which is the majority, typically require tremendous time and resource commitments from internal teams.
To help with the due diligence burden, typically a specialized due diligence company or consultant will be engaged to support the work. Firms like McKinsey, Bain or Boston Consulting Group, or the ‘Big 4’ accounting firms might also be engaged for large projects. Day rates at these firms can run into the tens of thousands of dollars.
Many investors tend to work with the same due diligence experts on acquisition due diligence over and again. Given the amount of information that must be processed, interviews sourced, and theories tested – to say nothing of the money invested – it is no surprise investors rely on providers they can trust. This can lead to significant costs when deals that don’t proceed are factored in to real cost of doing a single investment.
Conclusion
Commercial due diligence is an essential part of any acquisition or investment. At earlier stages of a company’s growth, it will inevitably be lighter touch than later in a company’s life cycle. Investors will always look to reassure themselves that they are making sound investment decisions, that they understand the target’s competitive position, and that their investment thesis isn’t flawed.
Companies generally rely on screening services provided by a due diligence expert or specialized firm. For example, many leading private equity, technology, healthcare and consumer brands choose to work with us at Unequal Outcome to support thorough commercial due diligence around potential acquisitions.
For founders going through commercial due diligence, perhaps for the first time, it is important to have a feel for the effort and expense that goes into the exercise by the investor. Understanding the sources and thought process of an investor in advance of a raise or buyout is advantageous, because many founders come to those initial discussions without having properly prepared their data room, or given advanced thought to what the sources an investor looks at might say about the company.
Ultimately, investors and buyers are looking to do a successful deal. A comprehensive diligence report is essential process for assessing commercial attractiveness and making a good investment. Investors will need to be satisfied they understand a company’s commercial, legal, and financial position to have confidence they are making a good investment decision.
FAQ:
What is commercial due diligence?
Commercial due diligence is a comprehensive assessment of a target company’s market position – their sales, marketing and operating model, their growth potential and current market share, the solidity of their customer base, the competitive landscape, their business plan, and any headwinds or tailwinds to the business. Each private equity firm, investor or buyer is likely to have their own commercial due diligence checklist of concerns they are looking to mitigate and hypothesis they’d like to validate.
Does this include a technical assessment?
No, normally a technical audit will be separate to any commercial due diligence audit, though they may run in parallel. However, it’s important to stress that when looking for growth opportunities, technology is a powerful tool in scaling operations cost effectively. Overall though, the commercial due diligence process is separate from financial, legal and technical diligence. All of these will typically be combined to create an overall due diligence report.
Is a financial analysis part of the commercial due diligence process?
Yes and no. This is one where terminology may vary between investors. Generally however a financial audit is a specific exercise designed to assess the company’s accounts and financial position at present. It looks at a company’s financial statements, and tries to assess its real financial performance. A commercial due diligence is however likely to include an assessment of a cashflow forecast, sales forecasts, future capital expenditures, and other opportunities like R&D credits. The commercial due diligence process is separate to the financial audit process.
Who provides due diligence investigation services?
Many well known firms like McKinsey, Bain, Boston Consulting Group and the big 4 accounting firms, as well as specialist firms like Unequal Outcome without the overheads and operating expenses of famous consultants. We are all engaged in helping clients make informed decisions either as investors or as a prospective buyer.