A short guide to due diligence of digital-oriented acquisition targets

By Sven Kleindienst, Marc Hesse, Fabian Neuen and Christoph Straub

With the number of transactions of tech-related assets booming due to their proliferation, investors need to be aware that specialist due diligence streams are required to assess digital-oriented companies. Here we look at the four main options – commercial DD, digital DD, tech DD and IT DD – and why only a holistic view can fully gauge the risks and opportunities.

The figures speak for themselves – investors continue to show a great deal of interest in digital business models. In particular, software businesses with a focus on SaaS models remain a hot topic, with almost 1,000 transactions in Germany alone in the past three years. Around half of these were acquired by financial services firms. Segments such as HR and Edtech, are also attracting considerable interest.

But investing in digital businesses is not like investing in traditional companies. They follow different rules and metrics, which need to be considered and analyzed in a different context to assess the attractiveness of a potential asset. This is especially the case for segments such as software, retail & e-commerce, marketplaces & platforms, or digital services. But it is also increasingly relevant for companies focusing on areas such as industrial products or non-digital services that have at least a partially digital customer journey.

As the way digital businesses and markets work differs from traditional models, new due diligence topics come into play – particularly digital, tech and IT due diligence. Combined with commercial due diligence, these provide a holistic view of a target, including internal and external risks and opportunities.

In this article, we explain what the different due diligence streams are, describe the focus of each stream, and outline why and when a commercial, digital, tech, or IT due diligence should be conducted.

Commercial DD: Essential but different for digital-oriented targets

Commercial due diligence is an essential element of all transactions. Commercial DD typically covers an analysis of the target's business model and USPs, the market environment (including an assessment of the size and growth of the addressable market), the customer and competitive landscape, and an assessment of management's business plan.

For digital-oriented business models, further specific analysis is required. To better understand a company's sustainable growth potential, it is essential to understand the target's KPI performance and unit economics. This means assessing ability to win new customers and convert them into returning ones, as well as the customer's lifetime value (CLV) compared to the acquisition costs (CAC). The analysis of customer cohorts, marketing performance, retention/churn and conversion rates, as well as unit economics (CLV/CAC), is essential here. Companies have often purchased their growth without being able to build lasting customer relationships, for example. In addition, digital business models offer a large number of data points (such as customer files with transactional data) that can and must be leveraged and made sense of.

A detailed analysis that considers these KPIs, alongside a holistic view that combines the findings from the other DD streams, is critical to evaluate the target's business plan and growth perspectives.

Customer surveys are also a useful tool. They can help to better grasp and compare how the target is perceived in relation to competitors, and to analyze the needs and market potential of different customer groups. Typically, topics here include net promoter scores (NPS), brand awareness (aided and unaided), purchasing behavior, and (digital) market potential.

In addition, a commercial due diligence summarizes the key findings of all streams to ensure a holistic perspective and assessment for the client.

Digital DD: The key to assessing a target’s digital growth and sales potential

A digital due diligence goes above and beyond a commercial DD. It follows a similar structure to the commercial DD but has a particular focus on the target's digital set-up and performance. This includes analysis of the company's digital team organization, ecosystem and strategy within the business model, the digital market potential, customer journey and sentiment, and its digital competition, including detailed benchmarks (for example, traffic, marketing performance, brand perception and engagement). This is complemented by an analysis of the company's top management and technology.

The digital DD thus gives the investor an all-encompassing view of the target's digital performance and growth potential. It also outlines concrete value creation measures for how to drive (digital) sales and profitability/EBITDA.

A digital due diligence is recommended for all business models with at least a partially digitalized customer journey. A comprehensive digital due diligence is essential in the case of pure digital players, while a holistic commercial due diligence with a specific section on the company's digital set-up is appropriate for companies with an enhanced digital focus.

An experience DD, involving an assessment of the design and user experience of a digital product or service, is typically integrated into a digital DD.

Tech DD: Assessing tech-related risks and future readiness

Tech due diligence is the process of evaluating a company's technology assets/systems and infrastructure to assess their current state and identify any potential risks or opportunities. The assessment delves into various direct tech categories such as software evaluation, security measures, development and deployment processes (incl. code health), architecture and data analytics effectiveness.

Additionally, the evaluation encompasses broader tech considerations including addressing technical debt, product strategy, development team, knowledge management, safeguarding intellectual property, overseeing vendor interactions, and ensuring compliance standards.

A tech DD aims to provide an objective assessment of the technology to enable informed decision-making and in-depth understanding of (deal) impacts. This allows risks associated with the target company's technology, such as lack of scalability, tech redundancy, security breaches, data loss and system failures, to be identified and mitigated. The insights generated also enable the identification of inefficiencies that can lead to cost savings.

The tech DD is, therefore, a critical process for any business that relies on technology. On the one hand, this applies to companies that sell software directly, offer services or products with software support, or have developed software to offer their product or service. By conducting one, businesses can be sure that their decisions and investments will enable them to stay ahead of the competition.

IT DD: Identifying the potential risks, opportunities and costs of IT

IT due diligence involves a thorough assessment of an organization's IT environment to identify and assess potential risks, opportunities and costs associated with IT assets and operations. It involves evaluating IT systems, processes and practices to determine their effectiveness, efficiency and compliance with regulatory requirements. The primary objective is to identify potential issues that may impact the value of an organization or result in financial, operational or reputational risks.

The scope of an IT DD typically includes a target's IT strategy and operations, IT organization and projects, applications and architecture, IT infrastructure, IT contracts and services, cyber security, data and analytics, and IT costs.

The IT due diligence is relevant for almost every business model. In an M&A context, an IT DD is particularly recommended for tech-oriented businesses and in the case of carve-out transactions/divestitures.

Other DD streams: From sustainability to operations

In addition to commercial, digital, tech and IT due diligence, other streams may also be of relevance. For instance, an operational due diligence enables better assessment of a target's internal processes and external supply chain, while an ESG due diligence assesses a target's alignment with sustainability targets.

Ultimately, the target’s business model determines which due diligence is required. For example, in the case of a potential acquisition of an e-commerce player, a commercial DD, tech DD, digital DD and experience DD would be essential, given that areas such as the architecture, market environment and competitive landscape need to be assessed.

Further details for digital assets.

Joining the dots – Why a 360-degree view is essential

The commercial, digital, tech and IT due diligence are highly interlinked. They will cover, for example, estimating the market size including the digital opportunity, expanding the competitive performance benchmarking to include digital KPIs, and analyzing customer behavior and sentiment.

Together, they enable a holistic view that is essential when evaluating a target's business plan and value creation potential. Aspects that need to be considered include the viability of the company's sales plan and drivers (CDD), digital/marketing drivers such as marketing performance and CAC (digital DD), and the scalability of the technology and IT infrastructure (tech and IT DD).