The due diligence process is synonymous with an overall medical review for companies. It aims at conducting an in-depth analysis of all relevant processes, departments, and environmental considerations to provide investors with a sufficient information level to decide whether to buy or not to buy a target company and at what price. Therefore, the due diligence process is also meant for identifying any pitfalls and deal breakers before the investor acquires the target.

The commercial due diligence process – the heart of the M&A process

What the America Online (AOL) and Timer Warner (2001), Daimler-Benz and Chrysler (1998), Google and Motorola (2012), Microsoft and Nokia (2013) and Kmart and Sears (2005) transactions all have in common, except for being well known as the five biggest mergers and acquisitions failures of recent history (likely also of all time), is that they are notorious for their lack of a (proper) due diligence, even though due diligences are part of transactions since the renaissance in Italy. If Daimler-Benz would have focused more on their commercial due diligence before acquiring Chrysler, they would have likely found out, that their cultures, especially on the top-level management, were clashing and that their employee compensation packages would not be easily harmonized with the philosophy Chrysler was following.

The mergers and acquisitions environment provides plenty of examples of the likes of the Daimler-Benz and Chrysler transaction, which highlights the importance for a due diligence process, especially a commercial due diligence. The commercial due diligence process is the heart of the mergers and acquisitions process and is carried out shortly before the handing in of the final binding offer and the share purchase agreement negotiations, as can be seen in Figure 1.

Figure 1: Mergers and acquisitions process chart

The due diligence process has the purpose of evaluating and verifying all relevant facts and financial information and to expose any existing red flags that may otherwise remain concealed from the buyer. The commercial due diligence takes a particular look at the current commercial operations of the company and ultimately aims at confirming or adjusting the currently existing business plan of the sellers. The process and contents are mostly alike for all companies with some minor but relevant changes when looking at E-Commerce businesses.

Figure 2 depicts the typical components of a commercial due diligence report for an E-Commerce company, split into the two separate phases of the due diligence, the red flag report, and the confirmatory due diligence report. The following evaluation is mainly concerned with the red flag report that precedes the confirmatory due diligence and represents the most important phase of the overarching commercial due diligence report. The following chapter will provide a deeper inside into the identification of red flags in commercial due diligence reports as well as giving insights to what extend these red flags may have an impact on the success of the transaction.

Figure 2: Commercial E-Commerce Due Diligence process chart and phases

Red flags – Identifying pitfalls and deal breakers during the commercial due diligence process

Red flags are not exclusive to commercial due diligence reports but can happen in various situations in peoples everyday (business)life. According to the Merriam-Webster dictionary, a red flag is used to “identify or draw attention to a problem or issue to be dealt with.” Therefore, the red flag commercial due diligence report for E-Commerce businesses has the aim to analyze the most critical business operations such as the product assortment, the sourcing and supply chain, the customers, and the E-Commerce organization to identify and finally flag grave problems in the executive summary. Red flags can often be the reason for investors to back out from a deal. Hence, the due diligence process is split into two phases with the red flag report being completed before the confirmatory due diligence, so that investors only pay for phase two if they decide to continue with the transaction.

Red flags are generally not made readily available by the sellers or their advisors and require some deeper analysis. However, there are certain red flags which are encountered frequently within the different sections of the red flag report. These red flags will be evaluated in more detail below.

Module I: Product assortment and sourcing & supply chain analysis

The focus in analyzing the product assortment lies on the margin profile of the products (often clustered into a set of categories) as well as the overall revenue contribution of a certain number of SKUs. In this context, red flags may arise when product categories contribute margins which are not high enough to cover the fixed costs of the operation. Red flags may also arise, when the company needs too many products in their portfolio to achieve their top line. The general pareto efficiency also holds for E-Commerce business models, roughly 20% of the SKU base generates 80% (or more) of the total revenue of the company. A thorough return analysis is also part of the product assortment analysis and aims at gaining a deeper understanding of the product quality. If the return rates are significantly higher than the industry average, it must be assumed, that the product quality does not reach general industry standard, which consequentially raises a red flag.

Red flags in the product assortment analysis will almost certainly lead to a reduction of the enterprise value of the transaction and may even lead to the termination of the mergers and acquisitions process. Red flags in the product assortment are problematic as they effect the top line revenues as well as the gross margins. Identifying red flags at this stage of the due diligence process means, that the company is either purchasing their products at too high prices or their customers are unwilling to buy the goods at higher prices. Furthermore, requiring too many products to achieve a certain revenue level also raises doubt in the overall potential of the business model. Exorbitant return rates indicate low product quality or issues in the quality management process. Overall, problems in the product assortment are among the most difficult to be fixed as the whole business model would need to be scrutinized. Therefore, most buyers chose to terminate the negotiations based on product assortment red flags.

Supply chain red flags on the other hand are a different matter, as they are mainly based on the dependence on certain suppliers and on environmental factors such as long freight routes (from China to Europe) and their idiosyncrasies. When challenging the supply chain and logistics of a company, the material cost share is analyzed to understand the bargaining power of suppliers against the analyzed company. The same analysis is done for freight forwarders where appropriate. Furthermore, external impact factors driving freight costs are analyzed (e.g., COVID-19 or the blockage of the Suez Channel).

If a company is heavily dependent on one supplier and one forwarder and must submit to their claims because their bargaining power is overwhelming, a red flag must be raised. Purchase prices dictate profitability (it is easier to purchase cheaper than to sell higher) and the company therefore requires at least a balanced negotiation standpoint with their suppliers. Forwarders are generally attributed comparably less importance, as the most important ones (i.e., Schenker, DHL, DSV, etc.) are big enough to always have the better bargaining position. However, the company should try to find a mix between large freight forwarders and smaller local providers to differentiate their risks and to not receive a red flag during the due diligence process. Overall, sourcing and supply chain issues can be mitigated much easier than issues with the product assortment (i.e., the business model). Therefore, red flags in this aspect of the E-Commerce due diligence report are likely to take a toll on total enterprise value achieved but are comparably less likely to be a deal breaker.

Module II: Customer analysis

After having thoroughly analyzed the product offering and the associated procurement of the products and materials, the angle of the customer must be taken into consideration as well. The analysis of the customers is concerned with an in-depth analysis of number of orders, average order value, total revenues and quantities sold on the different sales channels. Based on company orderbooks the potential of cross-selling is computed, the average order values of single customers and returning customers are calculated and the overall share of returning customers against one-time customers is observed.

The analysis of customers’ purchasing behavior has the aim to shed light on the value of the brand of the analyzed company. It is important to establish an E-Commerce brand to tie customers down and convince them to continuously buy from the same shop and brand. This is mainly controlled through the analysis of the returning customers share. It would certainly raise a red flag if there were close to no returning customers. This would raise questions about customer satisfaction, product quality and overall market potential. A red flag would also be raised if customers would not be subject to cross-selling (purchasing goods from different product categories), as it would raise concerns about the customer perception regarding portfolio diversification. Customer perception of the brand as well as customer loyalty are lengthy and costly to change, and hence a respective red flag will take its toll on the Enterprise Value of the transaction.

In a second step, market trends are analyzed to grasp the overall direction of the industry and to see if the business has tailwind from trends. As the overall E-Commerce market is experiencing a general upward trend, a red flag would generally be raised by companies acting completely contrary to global macro trends. Despite red flags in this analysis generally being a deal breaker, they rarely happen as companies rarely survive by acting contrary to global market trends and demands.

Module III: Analysis of the E-Commerce organization

The organizational structure of E-Commerce companies is generally much leaner; therefore, it is even more important to evaluate the quality of the organization as well as evaluating bottlenecks and dependencies on single employees. The management team of a company is usually one of the strongest drivers for a strategic buyer or a financial sponsor wanting to purchase a company.

E-Commerce companies are usually comparably young companies, which are still managed by their founders and often include friends (and/or family members) in key positions of the company. While this may be working out well while the initial founding team is managing the company, the wind may quickly turn as soon as new owners manage the company. Questions about their retention at the company arise; will they be willing to stay once the founders have left the company? Furthermore, these employees may often be overpaid (experience has shown, that this is especially true for family members). While family and friends being part of the company may not be a red flag per se, having them in all key positions of the company certainly is one. A red flag of this kind may require additional amendments in the share purchase agreement such as a lock down period for key employees for a predefined period so that the investors have time to find adequate replacement personnel. If the share purchase agreement negotiations do not lead to a solution, this red flag can certainly represent an insurmountable issue.

A similar red flag needs to be raised when single employees of the company represent the linchpin of the whole organization. When all key functions are centered around a single individual, he or she may be more influential than the owners themselves, as they decide the fate of the company through their operative role. This red flag needs to be addresses by the investors as they need to decide if they see a solution to reduce the responsibility of this person (keeping in mind the individual may churn and leave the company in this case) or if they decide to replace the person by a trusted individual or group of individuals from their network altogether.

Figure 3: Red flags and their impact level on transaction success & value

Once the red flag report has been completed, the investors must decide if they are willing to continue with the deal and hence with the confirmatory due diligence report. If red flags have been raised, the investors will decide on in their gravity, make amendments to their preliminary purchase price, and speak with the sellers to manage their expectations. Overall, red flags can be thought of as a pyramid (as can be seen in Figure 3), with the bottom being red flags raised concerning the business model, the middle being red flags concerning the management and key employees of the company and the tip of the pyramid concerning the customer perception. Customer views are moldable, it requires time and skill to change people’s perception, but it can be done. Exchanging the management team is possible but it requires large amounts of time and capital. Further, it may lead to disruptions of the everyday business which could harm the company in the long term. A flawed business model makes all hopes for the transaction to have a positive return on investment obsolete and burns capital in the long run. If the product assortment analysis leads to the realization, that the offered portfolio has low margins, and the company is at the mercy of their suppliers, the deal should be broken off and investors should search for another target which can add value to their portfolio.

 

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Markus Fost, MBA, is an expert in e-commerce, online business models and digital transformation, with broad experience in the fields of strategy, organisation, corporate finance and operational restructuring.

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Markus Fost

Managing Partner
Markus Fost, MBA, is an expert in e-commerce, online business models and digital transformation, with broad experience in the fields of strategy, organisation, corporate finance and operational restructuring.

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