Digital due diligence is now about future-proofing a company

Due diligence

By Phil Spratt, co-founder of digital intelligence service Deltabase – With the economic fallout of the Covid-19 pandemic suppressing some sectors, the attention of the private equity industry is now even more acutely focused on assets in the resilient SaaS technology sector and on firms that have successfully managed to ‘pivot’ towards digitalising their propositions and underlying business model.

Analysing valuation data through 2020 reveals that, as of 31 December 2020, the median valuation multiple for US public SaaS companies was 16.6x ARR according to data from SaaS Source. Applying the historical public-to-private market discount of 28percent, this gives us an estimated valuation multiple for private SaaS companies before applying further discount or premium for other factors of 12x ARR according to PwC Raise.

With multiples like these, it is easy to understand how management teams and vendors are keenly incentivised to position assets as SaaS ‘diamonds’, or at least as digitally future-proofed businesses.

Digitalisation permeates every aspect of a company

Satya Nadella has been vocal in his belief that “every company is a software company” ever since taking the reigns as CEO at Microsoft. As Nadella famously stated: “You have to start thinking and operating like a digital company. It’s no longer just about procuring one solution and deploying one. It’s not about one simple software solution. It’s really thinking of your own future as a digital company.”

Studying, in excruciating detail, the anatomy of the world’s leading companies – Facebook, Apple, Amazon, Netflix and Google, ‘the FAANGs’, – shows us that the modern sector-leading business has differentiating digital, technology, data and innovation capabilities woven into the fabric of its entire operating model.

The boardroom contains veterans of digitalisation who have innovated with technology and data and bear the scars of as many failures as successes. The company’s products and services are digitalised allowing for rapid scaling, cost-effective servicing, and high-quality earnings. 

Technology is leveraged to drive value and differentiation across all parts of the business from finance to HR to supply chain to marketing to the executive board room and everything in between. Data assets are captured, managed, and exploited to drive competitive advantage across all functional areas of the company.

Furthermore, employees are empowered to think and act in ways that encourage experimentation, innovation, and successful adoption of new ways of working.

Is today’s due diligence fit for purpose for today’s deals?

Every business can claim to be a digitally enabled business. Carefully peeling back the layers to separate the marketing bluster from true differentiating capability can be a complex task, especially during the time-limited due diligence window on competitive deals.

Through the 80s and 90s, when IT was commonly a bolt-on capability which enabled businesses to derive greater efficiency and competitive advantage, it was fine for IT due diligence to be a standalone exercise that sought to qualify risks such as technical debt that may be lurking in a company’s technology stack.

Through the 00s and 10s, ‘digital’ has earned its place as an important source of competitive differentiation and digital due diligence has found its way into deal execution plans - most often focused on how a company uses digital channels to engage its customers in marketing, sales and service.

Today’s reality, however, is that the digitally enabled and future-proofed business leverages technology, digitalisation and data in more profound ways than can be readily identified by traditional due diligence exercises.

Sorting the digital wheat from the analogue chaff

Finding assets which are truly positioned to win in their markets by harnessing the power of digital transformation requires a new take on due diligence. It requires the lens of ‘digital transformation’ to be applied to all parts of the business and applied across several forms of due diligence.

Many businesses, and their private equity owners, have been reminded about the importance of resilience through these difficult times and the correlation between resilience and digitalisation is born out both in the performance of FAANG stock - enjoying gains of between 33 per cent and 85 per cent in 2020 - and SaaS company valuation trends.

At Deltabase, we provide intelligence to private equity dealmakers that helps them zero-in on the current level of digitalisation of companies. Our 1,000-point assessment identifies and scores a company’s digital capability across the critical areas of strategy, business model, customer engagement, data, technology, and people & culture. When used pre-DD, it helps dealmakers work out where to direct due diligence attention to really understand how future-proofed, resilient, and differentiated target companies are.

A thriving deals market is sure to play an important role in the economic recovery from the Covid-19 pandemic and dealmakers everywhere will be sharpening pencils and tuning-in to both the opportunity and risk presented by digitalisation.
 

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