Digital Due Diligence: Systematic Assessment of Digital Growth Potentials of Companies

Co-authors: Dr. Stefan Sambol / Dr. Anja Konh?user / Toni Stork / Prof. Dr. Alexander Hahn

Digital markets are based on different rules compared to classic distribution channels. Therefore, a due diligence of a digitally focused company, which is to analyze the present position and future potential of a business, must employ additional key figures and evaluation criteria.

I. Introduction

A due diligence is carried out ahead of an acquisition or sale of a business (or any other investment) in order to assess and confirm whether the target company is a good investment. It is primarily done on behalf of investors and/or banks to provide them with appropriate information for an investment decision or financing. Business investments frequently carry high risks that ought to be stated and evaluated in advance.?At the same time, strengths and weaknesses of a company and its business model are analyzed and examined regarding its sustainability. In combination with an analysis of market development and trends, a realistic assessment of expected growth can be made. Due diligence is therefore the basis of any business evaluation to protect potential buyers or vendors from material and immaterial loss. It ensures that the key business data, facts and forecasts are correct, complete and collected accurately while being analyzed with appropriate care, i.e., due diligence.[1] While traditionally financial key figures (i.e., financial due diligence) were mainly examined within due diligence studies, numerous other areas like market or commercial due diligence have also become standard practice.[2] In Germany, a due diligence is primarily applied to the area of mergers & acquisitions (M&A) due to tight consumer protection laws.

?II. Markets in transition: The need for digital due diligence

E-commerce has transformed businesses and private lives around the world in a fundamental way. This shift to buying and selling on the internet has been caused primarily by technological change, including improved internet connections, digital maturity of market participants, growing internet affinity as well as a wide availability of easily applicable electronic devices. Even before the Covid-19 pandemic pushed e-commerce further, online trade was growing by ~20% annually, amounting to 14.1% of total retail trade in 2019.[3] Covid-19 has worked as a catalyst to accelerate the penetration rate of e-commerce in all product categories. This further stimulated the transition from traditional to electronic trade, allowing to reach figures that would not have been expected five years from now.[4]

Online distribution channels and online media have an important influence on sales. The reputation of a brand – independent of the distribution channel – is also increasingly determined online. Additionally, entirely new business models have been developed due to digitalization, including organizations that exclusively scale via online communities and social media platforms. Many businesses use influencers to reach target groups of diverse ages online.[5] Social platforms like TikTok provide new sales channels and business models. Young firms with digital business models as well as established medium-sized and large organizations with digital approaches are interesting investment objects from the perspective of companies that want to raise their digital competence and their technology expertise through M&A.

Digital firms differ in many respects from companies in the classical “analogous” economy. IT infrastructure for such digital companies becomes an integral part of the product itself.[6] Companies that achieve their performance by way of a best-in-class technology and infrastructure can improve their productivity by a factor of 3 [7] – showcasing new challenges for due diligence. Digital due diligence must query and scrutinize new criteria to accurately assess business value, scalability and potential value adds while forecasting the firm’s future growth. Furthermore, the availability of more relevant and analyzable digital data has allowed for continuous, fast, and precise adaption to market developments while at the same time played an important role in valuation of organizations. In this way, key performance indicators (KPIs), for example, may be pursued live and their development may be predicted with the help of intelligent algorithms.[8]

Overall, digital due diligence is a method to examine and analyze a firm’s unique position against competitors, sustainability of its digital business model, identification of potential risks and growth potential in digital channels. Aside from the market potential claimed by competitors, innovation pressure caused by global digital players like Google, Apple, Facebook, and Amazon also play a role in company valuation.

III. Analysis of digital business models

A digital due diligence addresses seven major aspects as explained below:

1.?Sustainability of the business model

Over the past years, digitalization has brought about numerous disruptive changes to many different markets. The most prominent example is the music industry, where initially the sale of music media declined due to MP3 downloads, and finally, the concept of music ownership was rendered obsolete through streaming services. Another example is the digital brokerage platform for services like Uber and Airbnb, which, without any capitalization, have become extremely strong competitors of the established classical suppliers, while at the same time being carried out by the idea of community and relying entirely on digital processes.[9] Through digital due diligence, investors want to find out whether the target company will be able to withstand future industry trends whilst scaling. Market research and trend analyses show whether there is a chance the market of the target company will change radically within the next five to ten years. Should this radical change occur, the risk of an investment will increase.

Even if there is no indication of disruption, a company should be resilient and be able to adapt to changed market conditions. This requires a well thought out business strategy that defines medium and long-term targets while also implementing market observation mechanisms. With regards to digital due diligence, auditors attach special importance to the state of digitalization and ask questions including: (I) what the extent of process digitalization and automation is, (II) what the digital ecosystem looks like (i.e., the partner environment for expanding one’s own product), (III) what the development potential is, (IV) in which area the company is best-in-class, (V) missing capabilities compared to competition, and (VI) which CAPEX / OPEX investments are necessary to close potential gaps?

2. Market analyses with the help of digital key figures

The success of a product, a business model or a company depends on the size of the market.?The traditional top-down approach uses market studies to determine the market potential and the market size. When starting a business, target population size and structure are determined, nearby competitors are assessed. A digital due diligence analysis will adapt the aforementioned analyses to the potential expansion of the business model within the digital market.

Digital markets are based on vastly different mechanisms than traditional retail trade. Hence, focusing on synchronizing online with offline channel strategies is important. However, as the total market grows steadily, the migration of customers towards the digital space becomes significant, causing online trade to show above-average growth rates. This offers enormous opportunity for companies pursuing a sophisticated digital strategy, allowing them to gain a foothold in markets that seem to be dominated by traditional firms. Therefore, there should be an evaluation of the historic online penetration while projecting the trend for upcoming years.[10]

3. Competitors in the digital business environment

An analysis of digital competitiveness includes direct and indirect competitors. While direct competitors offer the same or similar products, indirect competitors have different business models but aim for the same search engine traffic. This way, they directly affect the acquisition costs and the buying behavior of consumers. Online and offline performance may vary significantly when comparing such differently positioned companies. Local market entry barriers (i.e., country-specific certificates, particular customer demands, etc.) have different effects on competitiveness in each target market.

Companies that are market leaders, i.e., Amazon and Airbnb are characterized by their large product range, in-depth product assortment and special target group approach.[11] The market giant, Amazon, is a unique example, as they not only run their marketplace, but also act as an independent seller within it. Thus, Amazon can prioritize their own categories and products within the listed results and thereby is able to influence their own competitive position at the expense of other sellers.

To understand the competitive environment of the brand, a detailed analysis of the core competitors is advised. Parameters like online visibility (i.e., SEO Visibility Index that shows the visibility of a website in the organic search results), number of ranking keywords, social media presence, sentiment analyses (i.e., to recognize the sentiment towards a product mentioned in texts and commentaries) are important considerations within the analysis. Online channel performance as well as digital market shares together with their development in the organic and paid marketing channels over a given period indicate the market position and the potential of the company. Characteristics that differentiate organizations from their competitors should be emphasized and made visible to relevant stakeholders.

4. Digital perception of the brand

How well a business utilizes digital marketing and distribution channels has a direct effect on brand equity. The strength of a brand is determined by several factors including brand recognition, the subjective perception of customers, customer loyalty and brand reputation.[12] In short, the better known and popular a brand is, the sooner and easier will organic traffic be generated for one’s own channels. Generating organic traffic through a strong brand recognition significantly lowers the required investment into finding new customers via paid search terms on search engines like Google. Thus, a strong brand effectively lowers customer acquisition costs.

Aside from market strength, a company’s digital capabilities are important in pulling in potential customers through a range of different online channels while also tying them to the brand. This encompasses a social media presence fitting the brand, a differentiated approach to the specific use of influencers, the organic performance (i.e., measured in terms of organic visibility) on search engines, paid acquisition channels, and digital distribution channels that reach from individual web shops to marketplaces all the way to online apps. A brand with a wide reach as well as an above-average interaction rate can differentiate itself better from dominant marketplaces like Amazon.

Another important issue in assessing brand equity in the digital area is its resilience to change. For example, search algorithms are changing continuously while the significance of individual social media channels changes over time with different demographic groups. Possible uses of cookies which permit an easier traceability of users’ online route have recently been restricted in the face of new regulations. Most browsers have already built-in anti-tracking tools. Google is one of the major players who will follow the?Basic Data Protection Law (DSGVO)?while the so-called third-party cookies are to be largely forgone with many experts estimating that the conversion rate will decline by up to -30%.[13] Companies with digital business models must be able to adjust and find other means of generating user data.

5. Technology as an enabler for modern businesses

Digital business models are based on the use of information technology. Extremely high availability, flexible scalability, and the security of the IT infrastructure are from particular importance.[14] Many companies use their IT for data analysis to optimize their pricing and personalize their products. In practice, it is quite common for many companies to overestimate their digital capabilities. High digital competence raises market equity and the interest of potential customers – especially considering the current environment where there is a large number of mergers in the technology sector.[15] Digital due diligence must aim to examine the true digital maturity of a business carefully.

The IT infrastructure of a company must be able to adjust to growth processes quickly at transparent costs while supporting agile work structures. In such cases, it can be advantageous to involve specialized external partners and service providers. Cloud computing as managed solutions, for example, may be scaled based on business need and acquired without high initial investment.

Leveraging technology as a major growth driver for a business requires appropriate governance and security rules. These refer to the collection and use of customer data according to local legislation, and the application of secure software tools. The work environment of digitally driven companies is characterized by permitting video chats, implementing joint project planning, and collaborating on documents. Setting requirements regarding the use of tools will minimize security risks while also avoiding a proliferation of tools and programming.

6. Data-enabled customer (cohort) analysis

This is where a value-based analysis of customer behavior comes in. The basic questions when analyzing customer behavior include: (I) when does a customer become profitable, (II) how many customers buy repeatedly, (III) how many customers leave and (IV) what is the average number of returned goods? The aim here is to keep customer acquisition costs (CAC) stable or as low as possible and at the same time continuously raise the customer lifetime value (CLV).[16] A digital due diligence examines the development of these key figures over a period of time and compares those figures amongst different customer cohorts. The concept of customer cohorts divides a business’s customers into groups corresponding to their first purchase on a web shop. Hence, a yearly development of customer groups (“cohorts”) can be observed. While the behavior of customers does not solely depend on the channels where companies reach them, but rather the user interface (UI) as well as the related user experience (UX) become an important consideration when evaluating customer behavior. A precise and continuous analysis (i.e., A/B testing) will reveal potential improvements on an ongoing basis.[17]

The data collected for the analysis of customer behavior is extracted from business intelligence software, ERP of CRM systems. With intelligent CRM measures based on individual customer behavior, personalized campaigns can contribute to a positive development of CLV. Combined with the projected digital KPI’s, it is possible to estimate the effects of planned customer loyalty initiatives and find potential for further optimization – ultimately playing an important role for future sales growth.

7. Digital KPIs and their meaning for the business’ efficiency

An advantage in assessing digital business models is that there are numerous data points for evaluation and preparation of forecasts. Up to one hundred key performance indicators (KPIs) may be analyzed to evaluate the efficiency and scalability of the various online channels. For example, the number of visitors to the website (i.e., web traffic) during a given period is an important indicator of potential sales. It is recommended to take a close look at the individual channels used by customers, assessing whether they use paid search, organic search, direct contacts, affiliate marketing, social media channels or other campaigns (e.g., mail marketing) to reach the company’s website. The distribution across these channels yields a good picture over customer acquisition and the related costs when combined with conversion rates and the average size of orders.

Sources:

[1] Howson,?Due Diligence: The Critical Stage in Mergers and Acquisitions, 1st ed. 2003, pp. 1 ff.

[2] Harvey/Lusch,?Journal of Business Venturing?1/199 pp. 10ff.

[3] Bevh, “E-Commerce-Umsatz mit Waren in Deutschland in den Jahren 2000 bis 2020“, https:// fmos. link/11770 retrieval: Oct. 20,2021).

[4] OMMAX 2021, “The Art of Challenging E-commerce Topline Growth”, p. 1,?https://fmos. link/11771 (retrieval:?Oct. 20,.2021).

[5] Vrontis/Makrides/Christofi/Thrassou, International Journal of Consumer Studies 4/2021 pp. 617 ff.

[6] Lansiti/Lakhani, Harvard Business Review 11/2014 p. 4.

[7] Strasser, W&V 2018, Ranking Internetagenturen 2018,?https://fmos.link/11772. Benchmarking the top 100 digital agencies against an agency that was analyzed by OMMAX in the M&A process regarding due diligence.

[8] Saura,?Journal of Innovation & Knowledge?2021 p. 93.

[9] Teixeira/Brown, 2016 (revised 2018), Airbnb, Etsy, Uber: Acquiring the First Thousand Customers,?Harvard Business School Case 516-094 pp. 7ff.

[10] Hahn/Sandner/Knackstedt,?MRSG?5/2020 pp. 889 ff.

[11] Keller,?Journal of Marketing?1/1993 pp. 7ff.

[12] Swaminathan,?Academy of Marketing Science Review?6/2016 pp. 33ff.

[13] Sambol, “Online-Marketing: Die Cookie-Apokalypse naht “,?DUP Unternehmer?of 08.11.2021,?https://hbfm.link/12007?(retrieval: 19.01.2022).

[14]?Lansiti/Lakhani, Harvard Business Review 11/2014 pp. 7ff.

[15] Demling/Jahn, “Ausverkauf der Tech-Firmen“,?HB?no. 187 of 28.09.2021.

[16] Zeithaml/Lemon/Rust, 2001,?Driving customer equity: How customer lifetime value is re?shaping corporate strategy, pp. 53ff.

[17] Hahn/Riedmüller/Klug, in: Bookhagen/Rummler (Ed.), AfM: Arbeitsgemeinschaft für Marketing – PraxisWISSEN,?Innovation in der Marktforschung,?2020, pp. 100 ff.