Buyers’ wide-angle lens on your business

Part of the buyer’s due diligence process will be conducting commercial due diligence (CDD). If you are selling a small to mid-sized company, the concepts addressed here will be covered by the buyer’s diligence in a more abbreviated fashion under the umbrella of operational due diligence (ODD), a term which has a narrower meaning in context of larger M&A transactions. Not all aspects of this article will be relevant to your company, and the buyer will, of course, tailor CDD to the situation. But this material will allow you to ascertain what the buyer will likely be looking for when evaluating your company, and it will help you know in advance how you will measure up.

CDD is a process of evaluating a business’s plans and strategies against market performance and competitor strength to help buyers understand which companies are attractive acquisition targets and how much to pay for them. It investigates both the company and the markets in which it operates, relying on management information about the business and other primary sources like customers, competitors, and other market participants. We will introduce below situations in which the seller may initiate certain forms of CDD, but this article will focus primarily on the buyer’s CDD process to evaluate your company’s strategic position and growth prospects.

The Utility of CDD

Compared to the historical focus of other buyer due diligence work streams, CDD is focused heavily on the future. It tends to begin earlier than other due diligence work streams, since buyers often already operate in the target’s industry. The objective of CDD is to validate the company’s business plan. It is a deep analysis of how the company is organized, the market environment, market behavior, customer behavior, the company’s current and future competitive environment, and the sustainability of the company’s business model. 

Private equity (PE) buyers use external specialists to conduct CDD. Although corporate acquirers already operating in your market likely have a strong understanding of the business environment, it is still necessary for the buyer to synthesize it with analysis of the target, for a few important reasons.

• Investment decision. In addition to creating a clearer picture of the risks associated with an investment, CDD can also identify upside potential.

• Financing. CDD builds a case for bank portfolio managers when deal financing is being sought. If performed by a third-party consultancy, it also has the benefit of being independent.

• Post-deal value creation. Through CDD, the buyer gains a better understanding of the target’s environment, encompassing strengths and weaknesses as well as opportunities and threats. This better enables the acquirer to conduct post-merger integration (PMI), and informs initiatives to create value after the transaction, such as top-line growth or the generation of revenue and cost synergies.

The Different Types of CDD: Preparation and Use

Both buyers and sellers may have occasion to initiate CDD depending on the circumstances. Consultancies offer CDD services to both buyers and sellers, and they employ professionals with a mix of strategic consulting and M&A expertise. Sellers initiating CDD use these third-party vendors to establish credibility and objectivity. PE firms, which often do not have in-house CDD resources, use consultants as well for their capacity and expertise. Strategic acquirers with expansive corporate development departments may have the capacity to perform CDD in-house, but many use consulting firms specializing in CDD. There are four types of CDD:

1. Vendor CDD. Commonly referred to as vendor due diligence, or VDD, this is initiated by a seller who wants to attract more potential buyers, and to offer the buyer signing an LOI an opportunity to streamline the deal process. The consultant provides a comprehensive CDD report suitable for potential buyers and banks. Sellers typically incorporate VDD findings into their information memoranda, improving the information value of the CIM and attracting interest from more potential buyers. VDD is broad-scope, independent research with full access to the target. The report typically takes 6 – 12 weeks to complete. Because the process starts earlier and is intended for incorporation into the seller’s marketing efforts, it may be prepared under less time pressure.

2. Commercial fact book. Like VDD, a commercial fact book is ordered by the seller from a third-party consultant. It is a comprehensive description of the target and its environment, but it does not include any validation. A commercial fact book can typically be completed in 4 – 6 weeks.

3. Red flag CDD. Red Flag CDD is initiated by the buyer based on initial findings and concerns about the deal. It may be completed in 1 – 4 weeks, and it constitutes limited due diligence focusing on potential deal breakers identified or specified by the buyer. It is hypothesis-driven, based on desk research and interviews, with limited access to the target. It is appropriate when the buyer deems the deal to be sufficiently simple to warrant this approach, or when a commercial fact book or VDD is available that can be effectively bolstered by this targeted supplemental analysis.

4. Full-scope CDD. If full-scope CDD is necessary, it is generally completed by the buyer or their consultant in the 3 – 6 weeks diligence phase of the deal alongside the other diligence work streams. It is hypothesis-driven, is prepared with more comprehensive access to the target, and includes more thorough data analysis. Ideally, it will be a bankable report.

CDD focuses on things like macro trends, product technology, market share, volumes, and pricing. The buyer’s CDD consultant may interact with the personnel performing the buyer’s financial due diligence (FDD). CDD is prepared using a combination of:

• Company data. This refers exclusively to information supplied by the target. The CDD team will rely on various resources from the target’s data room. These include the prior year’s financial statements and business plan, management’s historical budgeting, YTD and monthly historical financial accounting, management’s commentary and variance analysis on historical performance and plan, industry research collected or performed in the past by management, up to date KPIs, and the company’s deal marketing information. Interviews with company management are also essential.

• Secondary research. Secondary research includes market studies, databases, and other desk research from various premium and free resources. It provides information on relevant market participants, industries, and commodities, as well as germane macroeconomic and M&A information.

• Primary research. Primary research refers to both desk research as well as studies and analyses designed and conducted by the CDD consultant’s staff. An example of the latter is conducting store visits to make direct observations. The CDD consultant will also conduct expert interviews. In addition to management Q&A, the consultant will access relevant industry/sector experts to form an independent view of the company, including customers/non-customers, competitors, suppliers, associations, university researchers, and other experts. The advisor may leverage their own internal CDD consultancy reports, and they may have to perform or commission customer surveys.

The CDD Process

The starting point for buyer CDD is a clear set of mutually exclusive and exhaustive investment hypotheses about the implications to the buyer for purchasing the target company. This ensures that the resulting report is not only factual and informative, but that it reaches specific conclusions relevant to the buyer’s central deal thesis for the acquisition and its criteria for a successful investment decision. This should be the basis for each aspect of the CDD.

Full-scope CDD consists of five primary components, organized onto three main levels:

These components are each summarized below.

I. Internal Analysis

1. Business Model Analysis

Business model analysis is the buyer’s basis for understanding the sustainability of your company’s architecture. The buyer will conduct a thorough analysis of your company’s business model to determine what products and services it offers, what customers it serves, and the sustainability of its position in the value chain. The objective of business model analysis is to ascertain if the business model in place today is going to work in the future.

Business model analysis helps the buyer determine how the company makes money. The buyer will rely on descriptive material and performance metrics in the data room, but management Q&A will play a central role in this stage of CDD.

The first step is to gain an understanding of the essential elements of the business model and how these are used to create value. The buyer needs to differentiate the determinants of value. These can be broken down into three levels and explored as follows:

• Value potential. What products and/or services does the company offer, and how do these create value? How is the company positioned in the industry value chain? Who are the customers the company serves? What customers does the company not serve? Management is a principal source of information in business model analysis precisely because there is so much variation from company to company. As the seller, use this opportunity to make sure your buyer understands important nuances of your position in the industry value chain that may have a not-so-obvious influence on the SWOT profile the buyer is forming for your business.

• Value creation. How does the company organize its own internal value chain? What is the horizontal scope of the various value chain activities? How breadth or narrowness of the company’s horizontal scope will be reflected in how much of each stage of operations is performed in-house vs. outsourced. This provides a qualitative picture of how much the company adds its own value at each stage or aspect of production. Value chain analysis also estimates each stage’s profitability contribution, not only in terms of its share of the product’s cost, but also its share of added value—i.e., its relative importance or significance in the value chain. For a simple product, for instance, packaging might account for 5% of the product’s cost under a particular business model, but the CDD team may estimate its importance to be 60% in terms of making a first impression on the customer and garnering market share. Different competitors in the same industry may organize their respective value chains into totally different business models, with different determinants of success. Remember that each business model has its own strengths and weaknesses, and the buyer may have novel ideas about how to leverage or improve yours. CDD gives you the opportunity to explain to the buyer the reasons you have organized your business model the way you have.

• Value capture. Which profit model does the company employ for translating potential into profits? How does the company protect profits from its competition?

Once the company’s business model is clear to the buyer, they need to understand how revenue scales. What has influenced the scalability of sales in the past, and what will influence it in the future? Corporate buyers will also consider the direct and indirect competitors they will face, and what synergies can be achieved.

While many consider performance metrics to be the domain of FDD, a solid understanding of them is crucial to CDD. Whereas much of FDD is concerned with validating the company’s reported performance, the adjusted numbers it produces are best evaluated in the context of the company’s business model. A deeper understanding of the company’s business model allows the buyer to better grasp all metrics related to sales and profitability. Understanding the historical development of the company in a deeper way allows the buyer to better evaluate its drivers of success and see its best path forward. For this reason, CDD will seek to break down revenue and EBITDA along dimensions not reflected in GAAP income statements, including:

• products
• regions
• customers
• channels
• business units
• sales KPIs

It is also important to understand revenue drivers in terms of the company’s core revenue model, prices and volumes, product vs. service revenues, old vs. new products, and old vs. new regions. It is not uncommon for the buyer’s CDD team to encounter data quality issues when seeking this level of detail in your data room. And depending on your company’s size, you may not be able to easily produce it as well as a company operating a mature enterprise resource planning (ERP) system. To the extent possible, accommodate the seller’s supplemental requests to provide breakdowns along the relevant dimensions of your business.

II. External Analysis

2. Market Analysis

Understanding the company’s market is fundamental to estimating its growth potential. The CDD team will have to both define and segment the market. Most companies, even large MNCs, operate in very tailored market segments, so there usually isn’t off-the-shelf secondary research that will accurately scope out the company’s market. Yet it is critical for the buyer to model the relevant volumes and prices reflected in the target company’s market historically. This can be a complicated affair when the market is multi-product and multi-regional. The dimensions along which the market should be modeled will vary from case to case, but they may include end-customer type, application, technology platform, or other meaningful differentiators.

To project the market into the future, it is necessary for the CDD team to understand the market drivers quantitatively, and to develop assumptions to forecast the company’s market. How can the relevant market be defined? How big is it? What is the industry’s life cycle position (introduction, growth, maturity, or decline)? What is the rate of market growth, what factors influence market development, and what significant changes are likely for the market in the future? Growth drivers can further be categorized as volume-related (GDP growth, end-user market growth, substitution, regulation, etc.) and price-related (capacity utilization, production cost, market concentration, competitor price positioning, etc.). For markets regularly impacted by product or production innovation, realistic price modeling also requires projecting how prices will decline as productivity gains are shared with the market over time. Supply and demand considerations are also relevant, such as the price elasticity of demand, and the future developments impacting the configuration of the industry supply chain. Further complicating this process can be the introduction of sensitivity analysis to account for estimation uncertainty.

Market analysis focuses on the company’s economic possibilities. But modeling the target company’s revenue and profits requires analysis of two other key external factors: customers and competitors.

3. Customer Analysis

Simply put, the objective of analyzing customer behavior is to determine whether the company’s customer position is sustainable. Using customer information provided in the data room and further inquiry of management, the CDD team seeks to answer important questions about the company’s customers. How is the customer portfolio structured? What are customer’s purchasing behaviors? How strong are dependencies? What opportunities and risks exist?

Customer analysis is organized around:

• customer base analysis; and
• customer behavior.

Analysis of the customer base is centered on the structure of the company’s customer base, how profitable these customers are, and key opportunities and risks of the company’s customer base.

• To understand the structure of the customer base, the CDD team will seek to segment it by relevant criteria, such as industry, region, sales channel, size, average duration of relationship, average transaction size, and average number of purchases. It may also be important to analyze customer retention and churn rate, and to conduct customer cohort analysis. To support further management Q&A and to summarize key insights for the buyer, the CDD team may prepare visualizations based on data provided by management.

• CDD teams attempt to conduct customer profitability analysis by segment based on data provided by management. It is not uncommon for deficiencies in the data to frustrate this analysis and prompt further questions from the CDD team. As the seller, the better you can support these CDD efforts, the more comfort you’ll provide to the buyer regarding how profitable customer targeting is conducted, and the ability of the company’s accounting systems and processes to capture and report activity with sufficient granularity along dimensions that are important to monitor and manage performance. The principal levers for increasing customer profitability are modifying the customer mix, lowering acquisition costs, increasing customer penetration, increasing customer retention, cross-selling, and up-selling. CDD seeks to understand the profitability landscape of the company’s customer base with a keen interest in identifying areas for improvement.

• A big part of understanding the sustainability of the company’s customer base is identifying opportunities and risks. With an understanding of the customer base in hand, the CDD team may seek to understand what new customers the company has won in the last three years, as well as why and how. Similarly, risks can be borne out with questions designed to identify which customers the company lost in the last three years, why, and how–as well as which competitors stand to gain. These changes might be idiosyncratic, or they may reveal important themes. Regardless, the CDD team will seek to understand the main risk to the customer base in terms of customer dependency and switching costs, demand-side consolidation, and vulnerability of key accounts. When the company is dependent on a few large customers that comprise the majority of its customer base and there are low costs for customers switching to other suppliers, the customer base embodies considerable risk. If the data is available, the CDD team will segment the customer base to summarize customer profitability using the Pareto Principle (the versatile intuition most people are familiar with in the form of the often-true 80/20 rule). Demand-side consolidation in the market can be one cause of outsized customer dependency by causing growth of key customers’ share of the client base. This is a double-edged sword because not only can it result in sales growth as market demand consolidates into an existing customer relationship, but it can also contribute to the loss of significant customer relationships as existing customers are consolidated into non-customer organizations. Past and prospective trends in the company’s market need to be examined to identify this. The CDD team will take a particular interest in large accounts to ascertain how secure they are in the customer portfolio.

Purchasing behavior analysis aims to understand more about the characteristics of customer behavior, and how the company’s business model manages the associated risks and leverages the resultant opportunities.

• Who are the key decision makers in the customer’s purchasing process? Some B2B businesses have customers that commonly use purchasing centers. But not all customers are identical. CDD will seek to understand how the company’s sales function figures out who the gatekeepers are, who has influence, and who makes purchasing decisions–and, critically, how they go about building relationships with the right people.

• What is the typical purchasing process? Understanding the context in which the customer’s purchasing function makes decisions for the company’s products means pinpointing how the company’s products fit into that customer’s production process (e.g., concept development, prototyping, tooling, production, assembly, etc.). Different industries will have different norms, and each customer will have its own process. What are the approval steps? How high are the hurdles to customer acquisition? What is the impact on customer retention?

• Which sourcing strategies are common among customers? When a customer uses a single sourcing strategy, the company is their only supplier for the product(s) the company provides. A dual sourcing strategy allocates a share of the customer’s business to the company and the remainder to a competitor; and in a multi-sourcing arrangement, the company is one of many suppliers for the customer. What is the prevalent sourcing strategy among the company’s customers and market? Understanding the company’s position within customers’ sourcing strategies is a factor in the sustainability of the customer base.

• What are customers’ key purchasing criteria (KPC)? This starts with understanding the characteristics of the company’s product(s), such as: physical characteristics of the product itself (performance, quality, features, aesthetics, durability, ease of use); quality and characteristics of the service or complementary goods the company offers for sale (post-sale services like training, complementary products, product warranties, maintenance contracts, quality of repair or service capabilities); and characteristics associated with the sale or delivery of the product (proximity to customer, quality of pre-sale technical advice, availability of favorable credit terms, speed or timeliness of delivery). Other characteristics that could be important include those that shape consumer perceptions of the product’s performance or cost to use (product’s reputation for performance, and/or the perceived staying power or financial stability of the company itself), and the subjective image of the product, as influenced by advertising, images, labeling, or prestige of distributors or outlets that carry it. Which criteria are important are those that matter to the customer base. Management’s estimates or surveys of customers can identify the most important criteria to the aggregate customer base, as well as quantitative scoring for each.

• Why do customers change suppliers? Part of CDD will be conducting churn rate analysis, including what customers the company has lost and the reasons why. If possible, the CDD team will conduct interviews with customers to understand why they switch. But more often they will rely on management’s perceptions about switching behavior.

4. Competitor Analysis

The goal of competitor analysis is not just to identify rivals and measure market share. It must come back to the company’s competitive advantage in creating and capturing value, and assessing whether the company’s competitive position is sustainable. The CDD team will gather insights from the company’s management presentation, interviews with management, and secondary research.

The three main areas analyzed are:

• the competitive landscape;
• relative financial performance of competitors; and
• drivers of financial performance.

Understanding the company’s competitive position starts with a picture of the overall competitive landscape. What are rivals’ relative competitive positions on the market? How has the competitive environment changed over time? How does management anticipate it will change in the future? Relevant competitors are direct competitors, potential rivals, and indirect competitors. Parties targeting some or all of the company’s market may differ from the company and from each other. They may differ in their market focus, their positioning in the value chain, as well as their vertical integration profiles and their horizontal breadth at the stages within their internal value chains. As part of understanding the overall landscape, the CDD team will seek to understand what differentiates the target company from its competition. The main factors defining the competitive landscape are competitive positions and the intensity of competition. CDD will seek to assess both.

• Assessing competitive positions includes both market share analysis and strategic group analysis. Market share analysis can be difficult to prepare, and usually requires a number of sources, including the market model produced through CDD, sales metrics obtained from the data room, management interviews, and secondary research. If applicable, it will present competitors’ shares of the market by region and in total. It is often summarized in a Marimekko chart (also referred to as a Mekko, mosaic, or matrix chart). To supplement this, the CDD team may also prepare a market share momentum graph, a two-dimensional plot of competitors in which the size of the bubbles depicts their relative market shares, their location on the vertical axis represents their market share growth rates over a meaningful time period (such as three years), and their placement on the horizontal axis represents their revenue growth rates during the same period. The intuition behind visualizing competitor position and performance this way is that competitors above the diagonal are those gaining the most market share, while the smaller competitors increasing their revenues while registering relatively smaller market share gains will be located below the diagonal. This allows for a more nuanced analysis. Strategic group analysis extends the same intuition used for a momentum chart, using bubble size to represent market share, but defines both axes using non-analog, mutually exclusive differentiating criteria. CDD will often depict a global competitive landscape in which a company operates by establishing discrete categories of product focus on the vertical axis (e.g., full range, mid-range, and specialist) and discrete categories of sales reach on the horizontal axis (e.g., national, multinational, and global). Once competitors are plotted, strategic group analyses form powerful visualizations of how competitors with different levels of market share cluster together.

• Assessing the intensity of competition involves determining market concentration, the balance between competitors, industry growth, fixed costs, size of capacity additions, product differentiation, switching costs, barriers to exit, and barriers to entry. Barriers to entry include behavioral barriers, such as using predatory pricing and holding excess capacity, as well as structural barriers. Structural barriers to entry include sunk costs and government protection, as well as customer barriers such as reputation, switching costs, and channel lock-up. Structural barriers to entry also include production barriers such as economies of scale, access to crucial inputs, learning curve, and legal barriers such as patents and subsidies.

Relative financial performance compares the financial performance of the target company to that of competitors. A bubble chart, similar in structure to that used for a market share momentum graph, is useful. The company and its competitors are plotted together, with the bubble sizes reflecting the competitors’ sales levels. The location of each competitor on the graph is determined by its EBITDA margin on the vertical axis and its sales growth on the horizontal axis. Each axis includes both positive and negative regions, distributing the company and competitors as follows:

• upper left quadrant: “Consolidators” (profitable shrinkers);
• upper right quadrant: “Performers” (profitable growers);
• lower left quadrant: “Retreaters” (unprofitable shrinkers); and
• lower right quadrant: “Inflators” (unprofitable growers).

Drivers of financial performance are related to the concept of value creation, which is central to the business model. Value creation differentiates between business models that are mainly based on cost advantage and those that are based on benefit advantage. A pragmatic way CDD analysts delineate between competitors is by the financial performance drivers of their business models.

• Competitors that focus on cost advantage to create value produce their products at a lower cost per unit than other competitors. This is often achieved through careful product design and producing output at a high volume to achieve scale in production. It can also be achieved by backward or forward integrating in order to capture more profit from the value chain. The drivers of cost advantage are size, input costs, and value chain configuration. These competitors generally have a clear volume model or technology model to keep costs down.

• Competitors whose business models rely on benefit advantage for value creation provide products that deliver higher perceived benefits to buyers than other competitors’ products, so their products command a price premium. There are various potential bases for advantage, such as offering better technology, a superior product, or a service component.

Different competitors in the same sector can have cost advantage or benefit advantage business models, thus appealing to customers with different KPCs. This allows the CDD team to plot all the company’s product attributes in two dimensions: according to relative importance to the aggregate customer base, the aggregate market, or segments of the aggregate market on the vertical axis; and relative performance on the horizontal axis. When a preponderance of the company’s product attributes falls within the upward sloping diagonal band in the center of the chart, it is indicative of a business model that is suitably competitive for the company’s market. Product attributes falling above/left of the band reduce the company’s competitive advantage because its offerings fall short on some dimensions, whereas product attributes falling below/right of the band can reduce competitive advantage because the company is incurring additional cost to provide incremental quality at diminishing returns to utility for the customer.

III. Synthesis

5. Business Plan Validation

Your business plan is both where CDD begins and ends. The culmination of the entire CDD process is the fifth and final step, business plan validation. The objective is to evaluate the insights revealed by the steps 1 – 4 (business model analysis, market analysis, customer analysis, and competitor analysis) and assess whether the assumptions underlying the business model that management has constructed as revealed in step 1 makes sense.

The CDD team will typically analyze the planning prowess of the target company’s management that will be staying on after the transaction. They will consider the company’s historical development and current situation, the quality of the planning methodology, and the historical accuracy of the company’s budgeting.

The CDD team will evaluate the key assumptions driving the company’s business plan. This will include comparing the historical growth of the company’s sales to the historical growth of the overall market for the company’s products, and perhaps the more narrow view of core regions in which the company operates. It will also include how these company and market series are projected to extend into the future. The analysts will also reevaluate whether the company’s business plan is achievable, including expected customer acquisition assumptions, price assumptions, capital investment assumptions, and other initiatives.

CDD thus provides a much richer and more robust context for developing a perspective on the company’s future prospects than FDD alone. It also provides a much more informed viewpoint from which strategic buyers can evaluate potential synergies and new growth options.

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