“The company grows and is profitable, then the technology will also fit.” This is how many investors look at the technology of their target companies. That can be fatal for your investment. Entrepreneurs, too, often are not involved in the technical aspects of their business down to the last detail and assume that, in the case of a positive company development, everything is in order from a technical point of view.
From our experience in the IT and software industry, we rely on a thorough technical due diligence (tech DD) before every investment at FLEX Capital. A procedure that we particularly recommend to companies that are actively looking for investors.
What is a tech DD?
Technical due diligence is part of every sales process – and is of interests to companies and investors. Here, the company’s IT is comprehensively analyzed, not only regarding its current performance, but above all with an eye towards the future. Is the companies technology suitable to achieve the corporate goals?
Four aspects are typically examined:
Is the IT basis designed for growth? Are work processes suitable to function steadily even when the company grows? Are there processes in place to quickly expand the team if necessary?
What is the maturity level of the product? Have patent and data protection issues been clarified? Is there a vision for the future of the product or are you satisfied with the current state? How strong is the USP?
With an eye towards the future, is there enough know-how in the team? How is the knowledge distributed? How is the workload of the employees?
Are modern programming languages and frameworks used? Are the IT architectures laid out in a comprehensive manner? What about the code quality? How are backup and recovery strategies designed?
Why a tech DD is essential
Investors should carry out such a tech DD before each investment for their own risk assessment. It does not matter whether it is a dedicated tech company. In many companies today, IT plays an important role in the company’s success that justifies the effort. In practice, however, the technical aspects are usually examined in a commercial DD, which is not sufficient for a well-founded assessment.
Entrepreneurs who are interested in selling always have a self-interest in carrying out a thorough tech DD before approaching potential buyers or investors. This is the only way you can work on deficits in advance and optimize the market value of your company.
As an investor we look below the surface
Very few investors are software developers and are able to understand the technology themselves down to the code level. A conversation with the CTO of the target company is mandatory, but not sufficient for a comprehensive review. At FLEX Capital we have the advantage that, for example, our partner Felix Haas has his roots in software development and can hold such discussions on equal terms with the CTO. Nevertheless, for us there is more to a technical DD.
As former internet entrepreneurs, we sense the situation in companies by intuition and draw an exact picture: What are the team dynamics like? How are the recruiting processes going? And how would working conditions and organizational culture have to be changed in order to retain tech talents in the company over the long term? From our point of view, these aspects are central to the future success of a company.
We work together with external experts for a comprehensive assessment. Only in this way can we derive reliable forecasts about the potential of the company.
Find the right provider for tech DD
When selecting providers, we make sure that they have many years of experience in the due diligence environment. We are looking for experts who have explicitly specialized in technological DD. Too often we have spoken to providers who have tech DD in their portfolio in addition to commercial DD and we couldn’t get rid of the feeling that their technical expertise is not much more pronounced than our own. Like this, a tech DD doesn’t make sense. The examiners themselves must have knowledge at CTO level in order to be able to identify weaknesses and risks.
Depending on the target company, we select our preferred providers from a small pool. Because software is not all the same and there are various business models for tech companies, the focus of the tech DD providers is also different.
Recommended course of action for companies ready to sell
Companies can and should do a lot to prepare and support the technical DD as part of their sales process. Because it is in the interests of both negotiating partners that the process runs smoothly.
The most important recommendation: involve your CTO as early as possible in the sales process. Ask him or her for an honest and detailed presentation of the most important areas of tech DD in the company: scalability, team, product and technology.
Include your CTO in the business planning and clarify which investments may be necessary before an initial sales pitch and which tech changes need to be planned in the future.
As the central contact in tech DD, your CTO should be able to answer any questions. Don’t leave anything to chance here, but support your CTO in the preparation of the interview. Many CTOs are more introverted and have had little reference experience in their careers. Therefore, coordinate the content of the answers in advance and, if necessary, offer your CTO the opportunity to role-play so that he / she can display the confident professionalism that you want your company to be represented by in the sales process.
Tech DD: key role in any negotiation process
At FLEX Capital, when selecting our investments, we look at health, profitable historical growth, the respective market environment and the quality of the team. However, that does not mean that we are focusing exclusively on commercial DD. Companies today cannot achieve sustainable success without a solid technological basis. Therefore, the tech DD plays an important role in any transaction negotiation.
We compare the results that the experts present to us with the company’s business plan: Are sufficient costs for technology planned? How great are the risks associated with the technological weaknesses? Can the risks be minimized through slightly higher investments or is there a risk of business collapse? In the worst case, the result of our analysis can mean an adjustment of the purchase price or even the termination of negotiations. In the end we stand by: Technology has to offer more than a good first impression.