The Power of Digital Due Diligence: Assessing Digital Growth Potentials

Digital markets are based on other mechanisms than classic markets. Due diligence analyzes a business's present position and future potential. This research aimed to develop a conceptual framework of relevant dimensions that encompass digital due diligence.

The following article was published in Marketing Review St. Gallen.

Due diligence (DD) is a process performed before the acquisition or sale of a business. It is a systematic assessment of whether the target company is a good investment on behalf of investors or banks. It supports the investment decision as such investments carry high risk and uncertainty. The strengths and weaknesses of the target’s business model are analyzed. Together with market and trend analyses, the growth expectations of the target can be estimated.

DD, thus, is the basis of any business evaluation. It ensures that key business data, facts, and forecasts are correct, complete, and collected accurately while being analyzed appropriately (Howson, 2017). Initially, DD focused on financial figures. Nowadays, market or commercial DD is also standard (Harvey & Lusch, 1995).

The need for digital due diligence

Digital firms have transformed markets fundamentally. Some global driving factors are high-speed internet, the growing digital maturity of firms, growing internet usage, and the global availability of electronic devices.

Covid-19 has accelerated this transition to electronic markets. Current e-commerce penetration rates of most product categories would not have been expected five years from now (OMMAX, 2021). Thus, the importance of online channels for customer acquisition for revenues is growing, especially for B2B firms. Brand reputation is increasingly created online. It enables new business models, such as startups, that scale exclusively via online communities and social media platforms. Businesses engage influencers to reach their target groups online (Vronits et al., 2021). Digital startups, as well as incumbent SMEs and corporates with digital approaches, are targets for companies that aim to increase digital competence and technology expertise via mergers and acquisitions (M&A). However, many companies struggle with their digitalization efforts (Gebauer et al., 2020).

Digital firms differ significantly from traditional ones. For instance, for digital firms IT infrastructure is an integral part of the product itself (Iansiti & Lakhani, 2014). Companies that use best-in-class technologies can increase productivity by a factor of three (WuV, 2018)[1]. Therefore, digital DD must have specific criteria for assessing business value, scalability, and potential value improvements for the targets’ future growth.

Moreover, for digital business there usually is a large amount of data available, allowing for fast and precise adaptations to market developments. This data enables live valuations of key performance indicators (KPIs) and in-depth analyses and predictions via intelligent algorithms (Saura, 2021).

In summary, digital DD is a method to examine and analyze a firm’s unique position against competitors, the sustainability of its digital business, the identification of potential risks, and digital growth potential.

Empirical Approach

The goal of this research is to develop a framework that encompasses relevant dimensions for digital DD. The dimensions should be collectively exhaustive and mutually exclusive. While more dimensions would guarantee exhaustiveness, parsimony calls for fewer dimensions with high explanatory power for the goal of estimating a target’s future growth.

Table 1 shows the research process and methods. Existing digital readiness frameworks were collected via academic databases and websites of transaction advisory service providers. Highly specific frameworks, e.g., focusing only on SMEs, were excluded. Table 2 shows the list of 7 cross-industry frameworks, each incorporating 3 to 9 dimensions. An initial Digital DD framework was derived based on the most frequent dimensions.

A qualitative study was conducted for which a semi-structured interview guideline was developed, pre-tested, and used for interviews with 6 experts. Each expert held considerable business and/or academic experience in DD as well as in digital transformation. Exemplary job descriptions are “head of corporate development,” “partner” at a transaction advisory company, “partner” at a digital consulting company, or “director” at a private equity firm. The interviews have been recorded, transcribed and analyzed via qualitative data analysis according to Mayring & Fenzl (2022). In summary, the results highlighted the increasing importance of digital DD. Due to time constraints in transactions, experts advised having a parsimonious digital DD, e.g., limiting the number of dimensions with a maximum of 3-5 KPIs for each dimension. Finally, the results validated the relevance of the dimensions of the framework.

Also, data on the structure of 100 digital DD projects was screened to validate the frequency of the dimensions of the existing models and to further define the specific KPIs. A quantitative online survey with 19 experts was conducted to further validate the relevance of the dimensions and reduce the complexity, ultimately resulting in a proposed framework for digital DD that encompasses eight dimensions, as shown in Figure 1.

Conceptual Framework for Digital Due Diligence

First, focusing on the Sustainability of the Business Model, investors want to assess the resilience of the target during future growth. Market research insights and trend analyses aim to detect radical changes in the focal markets within the holding period of the asset. The higher the likelihood of changes, the greater the investment risk.

Even without radical changes, a target should show resilience and adaptiveness to market developments. This requires a well-designed and executed business strategy with mid-and long-term goals in combination with market observation mechanisms. In digital due diligence, the following criteria are therefore addressed: (I) extent of process digitalization and automation, (II) digital ecosystem (i.e., the possibility for expanding product with partners), (III) market development potential, (IV) targets digital capabilities of being best-in-class, (V) missing digital capabilities compared to competition, and (VI) necessary CAPEX / OPEX investments for closing digitalization gaps.

Second, Market Analyses via Digital Key Indicators assess market size and growth as crucial factors. Traditional top-downs determine market potential and size via existing market research data and forecasts. Target population size and structure are determined, as are relevant competitors. Within digital DD, this approach is augmented with digital growth opportunities based on the potential expansion of the target’s business.

When the total market grows, and more customers migrate towards digital channels, digital channels grow faster than the market average. This calls for both the analysis of historic online market penetration and the projection of the digitalization trend for the upcoming years.

Third, Competitive Environment focuses on direct and indirect competition. Direct competitors have comparable offerings. Indirect competitors have different offerings but target comparable search engine traffic. Therefore, indirect competition also affects customers’ buying behavior and customer acquisition costs. Also, considering different local market entry barriers (i.e., country-specific certificates, particular customer demands, etc.) and that they might lead to different competitive levels is important for digital DD, as startups often seek to expand internationally quickly. Furthermore, there can be very tough digital competitive structures. For instance, Amazon runs a marketplace but also acts as an independent seller within. Thus, Amazon can prioritize its own products in customers’ search results and strengthen its competitive position.

Fourth, Digital Brand Perception focuses on the impact of digital channels on the target’s brand equity. Brand equity is determined by factors such as brand recognition, customer perception, customer loyalty and brand reputation (Swaminathan, 2016). For digital channels, the more known and popular a brand is, the sooner and easier the target can generate organic traffic. This reduces customer acquisition costs from paid traffic.

Besides brand strength, the target’s ability to generate and retain customers via a variety of online channels is assessed. This includes social media channels fitting the brand positioning, utilizing influencers, organic performance on search engines, paid acquisition channels, and digital sales channels, such as web shops, marketplaces, or mobile apps.

The target’s resilience is also affected by its brand equity. Search algorithms are changing continuously, and the role of social media platforms changes over time with different demographic groups. Regulatory actions affect central tracking technologies such as cookies, which allow for user profiling. Many browsers nowadays have built-in anti-tracking tools. Google is a major player in enforcing the General Data Protection Regulation (GDPR). The end of third-party cookies can result in conversion rate decreases of up to 30% (Sambol, 2021). Companies with digital business must employ alternative user data, such as first-party data, which is obtained on the brand own channels.

Fifth, Technology as Business Enabler focuses on the advantages of IT, which is fundamental for digital business.? For instance, nearly 100 percent website uptime, flexible scalability, the security of the IT infrastructure or dynamic real-time pricing are central factors (Iansiti & Lakhani, 2014). For investors, IT capabilities are a central driver for market equity (Handelsblatt, 2021). However, many companies overestimate their IT capabilities. Thus, digital DD must assess the target’s digital maturity carefully.

The IT infrastructure has to be scalable for growth at transparent costs while supporting agile work structures. Therefore, external partners and service providers often deliver best-in-class approaches. For instance, cloud computing as a managed solution is scalable at low initial investment costs.

Leveraging the newest IT also requires clear governance and security rules. User data collection and analysis must adhere to local legislation and requires secure solutions. Digitalized firms extensively use tools for video chats, collaborative project work or shared documents. Defining standard procedures minimizes risks while supporting agile work approaches.

Sixth, Data-driven Customer (Cohort) Analysis focuses on identifying customer value. Some questions for analyzing customers are: (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 returns?

The overall goals are minimizing customer acquisition costs (CAC) while maximizing customer lifetime value (CLV) (Zeithaml et al., 2001). Digital DD should analyze the development of these KPIs and compare them across customer cohorts. Customer cohorts divide the customer base into groups based on the time of their first purchase. Differing behavior between cohorts can be explained by mixed channels and, more importantly, changes in the user interface (UI) impacting the user experience (UX). Precise and continuous optimization via frequent A/B testing is important for maximizing customer equity (Hahn et al., 2020). To collect this data, state-of-the-art business intelligence software, ERP and CRM systems are important.

A central element for increasing CLV are personalized CRM campaigns. In combination with forecasting KPIs, such as digital market growth, future pay-offs of such customer loyalty initiatives in terms of sales growth can be estimated.

Seventh, the Usage of Digital KPIs is a central factor for assessing the target. For digital business there are numerous data points for evaluation and preparation of forecasts. Up to 100 KPIs may be used to evaluate efficiency and scalability of digital channels, e.g. the number of website visitors during a given period is an indicator of sales potential. All channels have to be analyzed to determine whether customer traffic is generated via paid search, organic search, direct contacts, affiliates, social media or other campaigns (e.g., mail marketing). This helps to assess the customer base and its profitability when combined with conversion rates and the average size of orders.

Eight, AI readiness is critical for the value and potential of target businesses. It encompasses processes, products, and people. For instance, process mining tools can optimize workflows to remedy bottlenecks and inefficiencies. Also, AI tools help identify customer satisfaction drivers in order to improve product quality in the product lifecycle. In the digital content industry, AI can automatically tag and categorize stock images, improve search and discovery functionalities, and enable companies to offer more personalization. However, AI also poses business disruption risks for incumbent companies in industries such as digital marketing, software development, or financial services. Companies that fail to embrace AI and to attract talent can be overtaken by AI-savvy competitors with improved efficiency, customer experience or product innovation.

Implications

The box “Lessons Learned” shows the implications of this article for investors, managers of targets, and consultants in the digital DD process. The findings of digital DD provide valuable market insights. In contrast to traditional business audits, digital DD considers key digital data, digital market development, and online potential. However, digital DD must be carried out with great care and profound expertise in digital strategies and practices, as digital KPIs are not easily interpreted and are sometimes misleading. Digital KPIs frequently suffer from strong fluctuations and mutual dependencies and are subject to higher dynamics than traditional business data.

Lessons learned

1. Investors, consultants, and managers should understand the growing importance of digital due diligence.
2. ?Investors, consultants, and managers should know the seven dimensions of digital due diligence.
3. Investors, consultants, and managers should be aware of the key analysis areas within the seven dimensions of digital due diligence.
4. Managers of startups and established companies should assess their own business model with regard to digital due diligence.
5. Consultants should consider developing traditional commercial due diligence towards digital due diligence.

Learn more about Digital Due Diligence at OMMAX.

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