As the private equity deal team evaluates an investment, there comes a point when top-line growth or go-to-market (GTM) cost out enters the deal thesis. That window often comes near the first-round bid. At this point, enough data and management access is provided to execute a meaningful Commercial Diligence effort.
Commercial Diligence starts with two fundamental questions:
Answering these questions requires an understanding of the target’s marketing, sales and post-sales organization as well as peer and competitive reference points. Deal teams must understand the model itself (motions, roles, organizational structure, etc.), as well as how it performs against key benchmarks including, sales and marketing expense to revenue, lifetime value (LTV) to customer acquisition cost (CAC), gross recurring revenue (GRR), net recurring revenue (NRR), productivity per seller, span of control, and others.
In addition to confirming the model and its past performance, the deal team must gauge the model’s ability to deliver results TODAY. If recent lead volumes, pipeline, win-rates, new account mix, and other leading indicators do not offer confidence in the business’ ability to deliver the proposed or modeled growth plan, management will be on their heels out of the gate. They will not give the needed mindshare to the value creation plan (VCP).
Finally, Commercial Diligence helps evaluate the management team’s ability to productively deploy commercial resources. Do they have the talent and experience to take the offering to new and adjacent markets? Do they have critical line management and operational roles in place to help the team scale? If the pieces to enable growth are not in place, the impact of value creation will be further delayed.
In this article, we will further explorer the two fundamental questions for Commercial Diligence to be done right.
|What is “Commercial Diligence?”|
|Commercial Diligence is not the “market work.” Market work is a critical input that helps the deal team understand the market size, growth drivers, target’s estimated share, and competitive positioning, and often includes customer research. These efforts produce a point-of-view on market attractiveness and customer value drivers. They often help the deal team understand the target’s “sweet spot” and identify parts of the market the target should attack. These efforts rarely explore the target’s ability to win those markets. They do not evaluate the target’s marketing, sales and post-sales engine. They do not produce an early view of the value creation efforts needed to bring the deal thesis to life. Enter Commercial Diligence.
While the length of due diligence might be months, a Commercial Diligence effort is completed in three to four weeks. The effort consists of primary research, data room absorption and analysis, benchmarking, management and supplemental customer interviews, and others.
Commercial Diligence produces an evaluation of the target’s go-to-market (GTM) model, answers key GTM and growth questions, details the future state needed to bring components of the deal thesis to life, delivers inputs to the deal team model, and lays out the value creation plan management must execute to deliver the anticipated return. The output enables the deal team to underwrite growth and gauge management’s willingness to implement a strategy.
Before investing in the go-to-market (GTM) model, it’s prudent to ensure the baseline model is sound and efficient.
Doing so starts with evaluating management’s pathways to growth. Has the management team fully fleshed out how they will deliver the growth plan? Are they missing anything? Worse yet, are they overly confident or pegging future growth to a narrow set of opportunities? A solid growth plan will incorporate multiple vectors including new customer acquisition, existing customer expansion, and retention (includes executing pricing strategy). A complete set of growth pathways will consist of introducing new offerings, entering new geographies, winning in new segments (e.g., enterprise, mid-market, small business), and bringing the solution to adjacencies.
Next, it’s important to determine if the management team has built a model that scales, or one that is overly reliant on a product or rainmakers. A scalable GTM model features separate marketing, sales and post-sales motions by segment―unit economics dictate a one size fits all model is inefficient. It is often the case that the business has not hit a size that affords differentiated motions or models. Additionally, productivity metrics may be underwhelming as scale benefits have yet to kick in. While these realities may be acceptable in the short term, a management team without an action plan for the next wave of growth is a red flag.
Growth portions of the deal thesis are often predicated on maintaining momentum in core markets while expanding to new markets. As deal teams evaluate a target, it is important to gauge the management team’s understanding and commitment to new organic growth pathways, as well as their plan to install the models and talent needed to win.
It is often the case that a target was successful in a core market. They may have been an enterprise-grade solution that needed to move downmarket for the next wave of growth. Or they are mid-market machines, and the R&D team has versioned the solution for Enterprise. Maybe they have a primary use case and have found new applications.
Regardless of the scenario, new or adjacent markets mean GTM evolution. The model that got the target to where they are today is unlikely to be the best and most efficient model for the next wave of growth. How a company builds awareness, stimulates demand, wins new logos, expands within existing accounts, and retains customers will differ by segment. Bespoke marketing, sales and post-sales motions and teams will be needed.
Entering new and adjacent markets often leads ownership and management to evaluate third-party channel options. Inevitably, someone comes forward with the idea to find alliances, resellers, distributors, agents or other indirect routes to market. These are certainly viable options, especially for entering new geographies, but managing a channel is difficult. Identifying, recruiting, establishing, enabling and maintaining a network of third-party channels takes time, commitment and investment. If the management team has yet to make significant progress here, it will likely take 18-24 months to see results from a consequential channel play.
Finally, new and adjacent markets require talent. People with unique skills are needed to win. Business development or hunting skills, people with industry or technical backgrounds, or knowledge of local geographies and cultures are prerequisites to winning in new and adjacent markets. The management team will need time to source, onboard and enable these resources. Lack of talent and know-how today will delay the impact of value creation initiatives.
Commercial Diligence is an important input when underwriting growth. It builds on insights from market work and prepares ownership and the management team to move quickly on value creation initiatives. Doing it right means evaluating opportunities to optimize the model and going into the investment understanding what the management team needs to build, enter and win in new and adjacent markets. An early view of commercial value creation initiatives helps align new ownership and the management team while improving the likelihood that the growth components of the deal thesis play out.
To learn more about how Alexander Group partners with Private Equity on Commercial Diligence and value creation, please contact a Private Equity practice lead.