Investing in a company without a thorough due diligence is like betting in a poker game without looking at your cards. A due diligence done right helps investors to decide whether it makes sense to proceed or whether it’s better to walk away from the deal. It is the all-important assessment to identify the target’s true value, evaluate risks and detect potential red flags.
Today due diligence has become more and more complex while investors often only have limited time to decide whether or not to invest. Hence, private equity firms, family offices or corporate investors rely on independent third parties such as BrightWolves to perform an effective due diligence before a key investment decision.
There are different types of due diligence: financial, commercial, operational and legal. In the next paragraphs, we will walk you through the essential steps of a sound commercial due diligence. Important decision factors to examine are market conditions, key industry performance issues, competitor analysis, product or service assessment, and hypotheses about the target’s full growth potential.
1. Analyse historical sales performance & current pipeline
Never assume the target company’s current business is stable, no matter how convincing the management of the target might be. Start with a profound analysis of the historical performance, usually over the past 3 years. Can one identify any trends in revenue, operating expenses and profit margins? Other metrics to dig into are customer growth, churn rate and quick ratio.
Next, take a closer look at the target’s pipeline. Although a pipeline changes every day, it still provides a picture of expected revenues. A good pipeline analysis should identify a gap between the starting, committed and budgeted revenue. A significant gap should be an important warning.
2. Understand market & competitive positioning
Now that you have more insights on how the target is performing, it is crucial to broaden the scope. Expert interviews and desk research should allow you to gain insights in the industry and find out the position of the target in the market. What are the main challenges? Who are the emerging competitors? Which technologies threaten the current business model?
On top of this, defining the total addressable market (also called total available market, TAM) will allow to estimate future revenue generation potential for the target.
3. Identify differentiating features of the product/service
Next to analysing cost structure and profits per unit, identify the differentiating features of the product and find out their possible competitive advantage. Is there any related pricing power? What is the next best alternative for customers?
4. Talk to customers
Customers can make or break a business. It is critical to know the target’s customers and understand the segmentation. By conducting customer interviews, you identify customer satisfaction, buying power, purchasing behaviour, willingness to switch, and willingness to pay. Examining the customer base enables you to determine whether the number of customers is legitimate or has been blown up. It will also give more insights into the target’s top customers and customers at risk.
5. Evaluate the marketing & sales strategy’s viability
This part of the due diligence should outline all expenses relating to marketing and sales efforts as well as the future growth strategies. To evaluate the business model viability, the most relevant metrics are Customer Acquisition Cost (CAC) and Lifetime Value of a Customer (LTV). The first one, CAC, is calculated by dividing all the costs spent on acquiring more customers (marketing expenses) by the number of customers acquired in the same period. LTV is the prediction of the net profit attributed to the entire future relationship, or the ability to monetize those customers.
When the cost of acquiring customers (CAC) is higher than the ability to monetize (LTV), it should be red flagged and brought to the attention of the investor.
6. Map the organisational structure
The current and future organisational structure is also an important aspect of a sound DD checklist. This part summarizes the management, the current employees and head count turnover. But it should also uncover any past organisational issues and give a first framework of the potential organisational structure after the investment.
7. Wrap up with key risks and mitigating factors
Now that all external and internal factors have been assessed, you should get a clear view of the company’s business model and current trading, the competitive positioning and the potential industry related challenges. Hence, the identified red flags should be listed, quantified and mitigated before making the investment decision.