Commercial Due Diligence: An Overview

To put it in simple terms, Commercial Due Diligence is the exercise conducted by the potential buyer or investor to find out the commercial viability and potential of a target company which it wants to buy or invest in. This exercise is usually conducted before the initiation of M&A deals as it provides the investor/buyer significant insights into the marker demand, revenue, commercial viability and competitive dynamics of the target company.

It must be noted that the exercise of Commercial Due Diligence begins at the strategic valuation stage before the deal is actually secured. It is usually conducted after short-listing the potential acquisition targets.

What is Commercial Due Diligence?

Commercial Due Diligence is the process adopted by an investor or a buyer to analyse the feasibility of investing or buying a target company from the viewpoint of its commercial performance. The aim of conducting the exercise of Commercial Due Diligence is to provide the buyer/ investor with an overall commercial perspective of the target company based on the company’s position in the market and how it is supposed to evolve in the future. The aim of commercial due diligence does not extend to identifying improvement potentials in the company; instead, its scope is restricted to analysing the target company’s business model from the commercial perspective and furnishing a report of its attractiveness from an investment point of view.

What are the objectives of Commercial Due Diligence?

The major objective of Commercial Due Diligence is as follows:

1. Identify the sustainability of the business: Commercial Due Diligence report provides insights to the buyer to identify the attractiveness and sustainability of the target company’s business model and its context.
2. Financial forecasting: Commercial Due Diligence helps in evaluating the future cash flows of the target company and further helps in financial forecasting of the target company which becomes a major deciding factor for the investors to make investment decisions.
3. Become aware of potential pitfalls: Commercial Due Diligence helps the investor/ buyer to assess the value of the target company beforehand and become aware of the potential pitfalls that could destroy the value of their shareholders’ stock.
4. Right valuation of theTarget Company: Commercial Due Diligence finally helps the valuator to reach the fair value of the target company and ensures that the investor pays fair value and not the value quoted by the target company to save the company from potential losses.

Steps involved in Commercial Due Diligence

A standard Commercial Due Diligence process looks as follows:

1. Strategic Rationale

The initial stage is the one of strategic rationale where the buyer/investor is making pre-qualification screening. The buyer does an initial analysis of the company. This is usually the stage of pre-due diligence where a decision is made after conducting desk-based, computerised research and doing online interviews. The pre-due diligence activity is generally done in large transactions. The final output of this stage results in making a non-binding bid to the target company.

The following factors are taken into consideration at the pre-due diligence stage:

• Identification of significant concentration of risk and any logistical issues
• Checking the contractual commitments of the seller
• Checking the direct procurements made by the seller

2. Doing the deal and Making the Offer:

This is the stage when the actual activity of Commercial Due Diligence is undertaken by the buyer. Commercial Due Diligence involves providing information by the target company and the investment bank, such as the information memorandum. The data room is established, and a series of questions and answers begin from the end of the management consultancy. Simultaneously, the management consultancy conducts internal interviews and external interviews, undertakes the requisite research and also conducts market studies with the aim of preparing the final assessment report about the commercial viability of the company for the buyer to take the final decision about going ahead with the acquisition or reject the acquisition altogether.

The following factors are assessed at this stage:

• The pricing strategies and elasticity
• Reviewing the length of the relationship, payment terms and customer credit-worthiness
• Reviewing the inter-company sales

3. Final Bid:

The final outcome of commercial due diligence activity is the buyer making the final bid to the seller to purchase the company’ having gone through the report prepared by the specialists.

Components of Commercial Due Diligence

Commercial Due Diligence is not a unidimensional process. It consists of a number of components. They are as follows:

• Key Findings of the company

The investor company goes through the scope of the services offered by the company and the company’s profile and takes an overview of the balance sheet, P&L account, and cash flow statement. The buyer wants to be aware of the general key findings and open issues of the company. A SWOT analysis is also done based on the operating model or USP. Further, contract and negotiation findings are also taken into consideration.

• Competitive environment

The buyer wants to know about the major competitors of the seller and where the market share is shifting. The buyer wants to find out the products and services offered by the seller and what is the USP of the products offered. Other related factors such as company strategy, gross margins, gross profits and also the strategy adopted by the seller to tackle these challenges.

• Size of the market

Special consideration is given to the prevailing external market conditions, such as the size of the market and how segmented it is. Both historical growth and projected market growth patterns are key to making decisions. Emphasis is also given to the growth drivers, the existing regulatory framework and the segment-specific trends in the market.

• Purchasing, Manufacturing, and Supply

The buyer wants to know the locations where the manufacturing is being undertaken by the seller, the production capacity of the plants, how quality management is being taken care of, what are its main supplier contracts, who is the purchasing organisation and what is the investment plan for the money invested by the buyer.

• Sales and customers

Another core aspect of commercial due diligence is undertaking the customer analysis and order analysis, finding out the product distribution channels, how it manages debt and the sales force along with 3rd party agents.

• Organisation and Personnel

Due consideration is given to the organisational structure of the business. The management quality and the services offered by them are tested during the exercise. Whether the business has a clear succession policy is also a matter of concern for the buyer. Further, other aspects related to the employees, such as employee productivity, upskilling of the human resource, pensions and payment systems, are also evaluated.

• Budgeting and Planning

Last but not least, budgeting and planning are the most crucial parts of Commercial Due Diligence, where an overall analysis of the earnings, cash flow statements and balance sheet is done. The financial forecasting systems and their accuracy are evaluated along with the sensitivity analysis. Evaluation of the business activity for the given year and forecasting assumptions are also done.

Checklist for Commercial Due Diligence  

The scope of Commercial Due Diligence is highly dependent on the number of products and services, market size and customer base the company has. Following is the basic checklist that should be part of every commercial due diligence process:

1. Market size of the company: It can be calculated in terms of Total Addressable Market (TAM) or Serviceable Available Market (SAM) etc. It should comprise the key drivers in the market, how the company is likely to expand etc.

2. Competition: This section should list out the major competitors in the market, their advantages and disadvantages, to what extent their product differs from your products, what are the entry barriers to your business etc.
3. Customers: This part must reflect the demographic characteristics of the consumers, their average lifetime value, their churn level, their experience with the company etc.
4. Company’s business plan: The diligence activity should reveal how realistic the business plan is in achieving the business objectives, can the plan be improved after acquisition is concluded and whether the plan synergises with the buyers’ own strategic objectives.
5. Sales and Marketing: The diligence process must show the annual budget spent on the sales and marketing of the product, how the sales can be improved, the average customer acquisition cost and whether effective marketing techniques are being employed to market their products.

Benefits of Commercial Due Diligence

Becoming aware of the true financial and commercial position of a target company in the market equips the prospective buyer with significant insights into the target company and consequently bestows a number of benefits upon the buyer. Some of the benefits accrued to the buyer by undertaking Commercial Due Diligence are as follows:

• Making informed decisions

It is not considered wise to make an investment decision based on an untested hypothesis. Commercial Due Diligence helps the buyers pursuing an acquisition to make informed decisions which further puts the buyer in a better position while making negotiations with the seller over the fair value of the acquisition. Being aware also allows the buyer to defend their position in a better manner.

• Assures shareholders of a good investment

Not all the acquiring corporations (buyers) have enough money to make the acquisition on their own. This requires them to turn to financial institutions to make up for the balance consideration. These financing institutions demand the Commercial Due Diligence report from the acquirer to check the feasibility of the acquisition, and accordingly, the payment is cleared. The acquirer has to assure its shareholders of the commercial viability of the acquisition, and the exercise of Commercial Due Diligence provides them with the required assurance to go ahead with the proposed acquisition.

• Apprises of the external effects of the business

The report prepared during the exercise provides an in-depth analysis of the external environmental factors having the potential to impact the competitiveness and market strengths of the target company. Having this knowledge beforehand equips the buyer to make better informed decisions and negotiations about the fair value of the acquisition taking into account the possible impact of the external threats and market conditions that could affect the future performance of the company in terms of its long term successes.

• Influence of the competitors on the market

The report also assesses the market and delineates the impact of the target company’s competitors on the target company. It helps to assess the potential growth of the target company and gives way to adopt appropriate marketing strategies in order to stay competitive in the market. A competitor analysis enables the buyer to better forecast the saturation in the market and potential in the market and ultimately helps you decide whether the proposed acquisition is worth investing in.