How Commercial Due Diligence are critical for Value Creation in M&A for Technology companies?

Introduction

  1. Legacy companies operating in matured industries are struggling to achieve growth organically due to decline in the demand for their core services.This has put pressure on the company management to protect and expand their market share.
  2. One of the biggest reason for this stagnation is the disruption of digital with new entrants in markets changing the incumbent business model.This change in the business model is achieved by the usage of cutting edge technologies like IoT, Cloud, Blockchain and AI that are altering the way how the business was done earlier.
  3. The legacy companies in order to protect their market share are looking to change their business model and employ latest emerging technologies like AI, IoT and Blockchain to improve customer experience and improve productivity.As the matured business do not have competency in usage of latest technologies and have poor understanding of how digital companies work, they are looking to acquire small digital companies/startups which can support them to build their digital presence and also understand the business model and the way of operating in this industry.
  4. After deciding to acquire, the buyer identify the areas where its services are being disrupted by digital and identify targets for acquisition in that area to protect and increase market share.

Acquisition Strategy for buyers to acquire Digital targets

As the acquirer is building its presence in a new industry where it does not have enough expertise, it can build its acquisition strategy in two ways:

  • Corporate Venturing – Build a corporate innovation fund that will invest money on new age startups using latest technology like AI, Blockchain as their revenue model.By building a portfolio of investments, the buyer can get a high level understanding of the latest technologies and how it can be used as a business model to generate revenues.The company can invest in early stage startups to late stages financing and occupy board seats in invested companies to observe how the startups with their service offering is able to build a market share by acquiring customers.The investor as a board member should be in a position to leverage the startups expertise in improving their own service offerings.
  • Acquiring small companies – Alternatively, the acquirer can acquire small companies that have a focused service offering which is of interest to the buyer.The acquirer can acquire the target and integrate it with its business unit to strengthen its existing services or build a new service offering.Most of these are bolt on acquisitions and are rolled up to the relevant business unit. Acquiring small companies do not pose huge risks to the acquirers as it does not disrupt the acquirer operations when integrating its business.Even if these acquisitions fail, it will not incur huge loss to the acquirer.The acquirer can learn valuable lessons from the acquisition which can help it in future.

After finalizing on the acquisition strategy, the buyer identify and evaluates the target based on the strategic drivers and its attractiveness. A business case is built to justify the acquisition along with an initial valuation based on the data provided by the target management.

Why Commercial Due Diligence is important?

  1. Due Diligence is done by the buyer to confirm its investment thesis on the attractiveness of the target company and the value it will bring to acquirer with this acquisition.
  2. Commercial Due Diligence involves understanding of the Target Business and target industry in detail.This analysis is done to identify the growth drivers in the industry and value generating levers in target business.

The Commercial Due Diligence involves evaluating external and internal factors.

  1. External factors involves understanding the target industry, growth drivers, macroeconomic risks like effect of regulation and political disputes like trade war.For instance, cross border acquisitions involving AI, requires approval of CFIUS to close the deal.Political issues like US China trade war, will make it difficult for Chinese companies to invest in US companies.
  2. External factors also involve identifying the market players operating in the target industry, their market share and how competitors perform compared to target.In many cases, acquisition of target company would alter the way how the competitors would react and the buyer needs to plan for this reaction.
  3. Acquirer should also evaluate if the target industry is a buyer or seller market along with entry barriers for new business and switching cost for customers to move from one supplier to other.
  4. Access to talent or availability of skilled labour in the target industry is also an important factor.Labour costs are important as it affects the overall profitability and acquirer needs to factor the same while evaluating the target.

Internal Factors

  1. This involves understanding the overview of the target company, its business operations, key locations along with its customer/employee base.
  2. Other important factors would be how the target generates revenues, its value operating levers and whether its services are in differentiated to demand premium pricing from its customers compared to its competitors
  3. The quality of the employees, their skillsets and capabilities along with the hiring strategy of the target company needs to be evaluated.Is the target company able to hire the best possible talent from the market and whether they are able to retain their employees with their working culture are the parameters that needs to be evaluated.

Conclusion

  1. Commercial due diligence is extremely critical for the acquirer to understand the target industry and the target company in detail to arrive at a decision whether the acquisition can add value to all the stakeholders.
  2. In successful acquisitions, the acquirer is required to add value to the target company by either investing on their growth, transfering their skills and sharing their capabilities with target.
  3. Inadequate commercial due diligence by not understanding the target industry in detail can pose a huge risk to acquirer causing value destruction. Instance like Microsoft and Google acquisition of Nokia and Motorola handset business were classic examples where the acquirer failure to understand the target business and industry resulted in them writing down their acquisitions subsequently.


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