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Commercial Due Diligence: Explanation, Checklist

Commercial due diligence forms an important building block in the examination of a company before and during a transaction, analyses the market and in particular the value chain of the business model and answers the question of its sustainability.

The main points of a commercial due diligence investigation are:

  • Business model
  • Market position
  • Strategy

In contrast to the other types of due diligence, commercial due diligence is primarily interested in the future development of the target company and its market environment. 

Based on a comprehensive and in-depth detailed analysis of the market and competitive environment as well as the customer portfolio, the business planning and in particular the planning assumptions made are validated. 

The focus of interest is the question of how secure and resilient the current customer relationships are and what future growth potential there is with existing customers and new customers. The greatest customer-side risk is always the loss of a major customer after the transaction. 

One of the core tasks of commercial due diligence is to conduct expert interviews in the market with e.g. suppliers, trading partners, competitors and customers to determine the perception and positioning of the target company in the market. 

Sometimes the terms strategic due diligence, customer due diligence or market due diligence are used instead of commercial due diligence. The term commercial due diligence is the most common.

Commercial due diligence questions

Numerous questions have to be answered in the course of the commercial due diligence process. Here is a small selection:

Goals and strategy

  • What financial goals is the company pursuing?
  • What pricing strategy is the company pursuing?
  • How has the product and service portfolio developed over time?
  • In which markets is the company active?
  • Which sales channels are chosen?
  • Which customer groups are served by the company? Which are not served?
  • Does the company have a balanced customer portfolio?
  • What is the company’s position in the value chain?

Company description

  • What is the organisational structure of the company?
  • What is the composition of the management team?
  • How many employees does the company have?
  • What value-added activities do the company cover and what are its core competencies?
  • How does profitability differ between the company’s business units?
  • What power do supplier companies have?

Market definition

  • What is the relevant market?
  • What are the market segments?
  • According to which criteria can the segments be differentiated?
  • Will this segmentation change in the future?

Market size and development

  • How large is the relevant market or market segment?
  • How is the relevant market developing? 
  • How attractive are the individual segments in terms of volumes and prices?
  • How will the segments develop in the next 3-5 years?
  • In which stage of the life cycle is the relevant market?
  • How cyclical is the relevant market?

Buying behaviour

  • Who are the key decision-makers in the purchasing process?
  • How does the customer’s decision-making process work, which individual decision-making criteria does it go through?
  • What are the customers’ key purchasing criteria?
  • How are these criteria weighted?
  • How well does the target company fulfil the purchasing criteria?
  • How will the purchasing criteria develop in the future?

Customer structure analysis

  • What does the customer structure look like?
  • What are the purchasing volumes of existing customers?
  • How does the profitability of individual customers differ?
  • Which sales channels are used?
  • What is the importance of existing customers for the company?
  • How are dependencies on customer groups to be evaluated?
  • What is the origin of the dependencies or how can the dependencies be described and evaluated?
  • How will the customer structure change in the future?

Strengths and weaknesses compared to competitors

  • What are the sources of competitive advantage in this industry?
  • What are the success factors in different market segments?
  • What is the distribution of customer-related market shares?
  • How is the company positioned concerning critical success factors, vis-à-vis competitors?
  • What are the strengths and weaknesses of the company relative to its competitors along the value chain?
  • How is the company positioned concerning its purchasing competence (supplier management, commodity group management, procurement organisation, global sourcing)?
  • How is the company positioned concerning production?
  • Does the company have logistics competence?
  • How is the company positioned concerning sales-related activities?

Risks in income and profit planning

  • What are the key risks to revenue and profit expectations?
  • What is the detailed milestone planning (3-5 years)?
  • What are the strategic and operational steps of the planning?
  • Comparing the business development of the last 5 years, is the planning for the next 3-5 years realistic?
  • Consistency of the parameters, benchmarks and key figures used for the historical development and planning or planning horizon (qualitative and quantitative measurable goals)?

Possibilities

  • Is geographical expansion possible?
  • Is it possible to expand the product and service portfolio?
  • Is it possible to develop further customer segments?
  • Are price increases possible?
  • Is the acquisition of smaller competitors possible?

Private equity commercial due diligence

Commercial due diligence reports are usually commissioned by private equity companies. They are rarely commissioned by strategic buyers. 

Private equity is private equity capital provided by banks, insurance companies, pension funds and other institutional investors. This capital is used to acquire stakes (especially majority stakes) in companies. The return on investment (ROI) depends on the increase in value of the target company throughout the investment. 

To achieve a high ROI, investments are made selectively after comprehensive prior due diligence. The increase in value is usually achieved through organic company growth, by pursuing a “buy and build” strategy or through targeted restructuring measures. 

The holding period is usually three to seven years but depends on the performance of the target company. 

Depending on the size of the target company, the divestment (exit) takes place either through a sale to a strategic investor (trade sale), to another financial investor (secondary buy-out), an IPO (initial public offering) or, in rare cases, to the existing shareholders (buy-back). 

For the fundraising, the investments and the management of the holdings, private equity companies receive an annual management fee, which is usually around 2-3% of the fund volume. In addition, private equity companies are remunerated through profit sharing.

The financing of an investment is often realised in the form of a “leveraged buy-out” (LBO). In this form of financing, a significant share of the transaction volume is covered by debt capital, whereby private equity companies use the debt financing share as leverage to increase the return on equity in the course of the investment.

Conclusion

Many of these questions can only be answered in discussions with those responsible at the target company. Often, therefore, extensive interviews will have to be conducted as part of the commercial due diligence.

This is the only way to make meaningful strengths, weaknesses, opportunities and threats analysis for the company and to determine what effects various scenarios will have on the future development of the company.

The findings from the commercial due diligence are transferred to the planning calculations and thus form the basis for the company valuation.

At this point, the commercial due diligence transitions into financial due diligence.

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