Michael’s M&A Playbook: 5 Tips for a Successful Commercial Due Diligence

In a buy-side due diligence process, you analyze the target company and try to understand whether buying the company will add value to your business. The analysis needs to include a market analysis, the target's business model, go-to-market strategy, operational processes, customer service, and administrative procedures to develop a value capture approach, also called an investment thesis. The commercial due diligence is an essential element of the mergers and acquisitions process. It is at the heart of understanding the competitive market position of the target company and digs into other aspects of marketing and sales. Here are some examples and best practice tips that go beyond a simple commercial due diligence checklist and will help you in your next M&A transaction.

Best Practice Tips for the Commercial Due Diligence

1. Understand first the market and the target's competitive position - It is often difficult to define a precise addressable market because market and industry borders blur more and more. We see this in a business analysis and also in legal battles about market power and competition laws (where defining the market is fundamental). On a positive note, blurring market lines allow you to address clients in similar but slightly different markets. On the other hand, it also allows competitors to enter your market. Start the market analysis with a basic description and analysis of the primary market and the market dynamics. Those questions include whether the market is growing, how competitors enter and exit the market, whether substitute products are available, and how the M&A situation is (e.g., market consolidation with significant M&A transactions). The next step is to understand how the target company compares to its competitors and how the competitive position has developed over the last years. An important data point is the market share. In some industries, this is readily available; in others, it is more complicated, and you need to work with estimates.

2. Continue with the business model and go-to-market strategy before digging into the details - What is the elevator pitch of the target company? That is the leading question to understand the target's business model and how they try to find, win, and keep customers, which is the go-to-market and client retention strategy. Talk with senior marketing executives of the target company to discuss their marketing approach. My method is to use the four Ps (product, price, place, and promotion), which is a simple technique and addresses the basics. Talk in parallel with the sales executives and get their story on how they implement the marketing strategy in the sales process. Sometimes, you will hear inconsistent messages between the marketing and sales managers, which is also an excellent opportunity to learn more about how the target manages those conflicts.

3. Dig into the details of the client list and revenue development assumptions - Now it's time to start digging into the details of the data. What are the target's customer acquisition costs (CAC), customer lifetime value (CLV), and churn? Those are some of the fundamental metrics in understanding the marketing and sales basics of the target. When does the target recognize revenue? This is an essential accounting question that also the financial due diligence team should ask. For this topic, ensure that the commercial and financial due diligence teams work closely together. As the acquirer, you want to learn as much as possible about the existing customer list. Sometimes, you need to work with anonymized data (e.g., when you want to buy a competitor). Nevertheless, it will help you to get more data about customer concentration. Are there a few clients with the majority of the revenue? If yes, this would be a risk. The basic planning assumptions for future revenue development are another area of the analysis. How much do the assumptions differ from historical metrics, and how do they compare to market benchmarks?

4. Understand the target's gross margin calculation - Companies calculate the gross margin differently. There is no single method; you need to dig into the details of the specific target's accounting and management reporting. For example, I have seen in project organizations the remaining costs of the project delivery team as costs in the gross margin or as OPEX (below gross margin), which makes a significant difference in the analysis. Other examples of differences in my transactions are how the target calculates the hourly rates (for the charge from the cost center to the project), how they deal with overtime (e.g., 50 hours worked in a 40-hour week with or without overtime payment), and where they book accounts receivable write-downs/-offs (i.e., in a cost center in OPEX below the margin or on the project in the margin). Adjust the calculation if necessary to compare it to your management reporting.

5. Benchmark marketing and sales costs for potential synergies - Understanding potential synergies has been a constant topic in my M&A transactions, including the marketing and sales functions. Sometimes, it remains an analysis without specific restructuring actions; however, it is still part of the analysis. Some valuable metrics are marketing expenses/revenue, revenue and margin per sales headcount, and revenue and margin per total headcount. Those are good starting points; however, customer relationships are complex to analyze, and you should not rely on a few metrics. I strongly recommend including qualitative aspects in this area of your analysis. I am always cautious before changing anything in the sales organization of a target.

Summarize Everything in the Commercial Due Diligence Report

If you follow those steps, you will have a lot of information about the addressable market, market dynamics, competitive position, go-to-market strategy, client retention approach, and marketing and sales metrics from the target. The question now is how to communicate this in a commercial due diligence report. I suggest being as straightforward as possible. The more data and information you have, to more essential it is to have a due diligence report that is simple and clear. You don't have to do it all by yourself. Many experienced commercial due diligence providers can help you.

Feel free to contact me to discuss specific mergers and acquisitions examples.