“The company is growing and profitable, so the technology will be fine.” This is how many investors look at the technology of their target companies. For their investment, this can be fatal. Even entrepreneurs often don’t delve into the technical aspects of their operations in detail and assume that everything is fine from a technical standpoint with positive company development. From our experience in the IT and software industry, we at FLEX Capital conduct thorough Technical Due Diligence (Tech DD) before every investment. This is an approach we particularly recommend to companies actively seeking investors.
What is behind a Tech DD?
Technical Due Diligence is a crucial part of any sales process and is in the interest of both companies and investors. During this process, the company’s IT infrastructure is thoroughly analyzed, not just in terms of its current performance but also with a focus on the future. Is it capable of helping the company achieve its set business goals?
Four fields are typically examined:
Is the IT infrastructure designed for growth? Are work processes suitable to function smoothly even with company growth? Are there processes in place to quickly expand the team when needed?
What is the maturity level of the product? Are patent and data protection issues resolved? Is there a vision for the future of the product, or is the current state considered satisfactory? How strong is the Unique Selling Proposition (USP)?
With an eye on the future, is there enough expertise within the team? How is knowledge distributed? What is the workload of the employees?
Are current programming languages and frameworks being used? Are the IT architectures well-structured? What is the state of code quality? How are backup and recovery strategies implemented?
Why a Tech DD is indispensable
Investors should conduct such a Tech DD before every investment for their own risk assessment. It doesn’t matter whether it’s a dedicated tech company. In many companies, IT plays an important role in business success, justifying the effort. In practice, however, technical aspects are often included in a Commercial DD, which is not sufficient for a thorough assessment.
Sales-oriented entrepreneurs have a vested interest in conducting a thorough Tech DD before approaching potential buyers or investors. This allows them to address any deficiencies in advance and optimize the market value of their company.
We look below the surface as an investor
Very few investors are software developers and capable of understanding the technology down to the code level themselves. While a conversation with the CTO of the target company is mandatory, it is not sufficient for a comprehensive examination. At FLEX Capital, we have the advantage that our partner, Felix Haas, has his roots in software development and can engage in such conversations with the CTO on an equal footing. However, for us, a Technical DD involves even more.
As former internet entrepreneurs, we have a good sense of the situation within companies and create a detailed picture: What are the team dynamics like? How are the recruiting processes? And what changes would need to be made to working conditions and organizational culture to retain tech talent in the company in the long term? From our perspective, these aspects are central to the future success of a company.
For a comprehensive assessment, we collaborate with external experts. This is the only way to derive reliable forecasts about the potential of a company.
Finding the right providers for a Tech DD
In selecting providers, we ensure that they have many years of experience in the due diligence field. We look for experts who have specialized specifically in technological due diligence. We have often spoken to providers who include tech due diligence in their portfolio alongside commercial due diligence, and we couldn’t shake the feeling that their technical expertise was not much more advanced than our own. In such cases, a tech due diligence wouldn’t make sense. The assessors themselves must have knowledge at the CTO level to uncover weaknesses and risks effectively.
Depending on the target company, we select from a small pool of our preferred providers. Just as software is not all the same and there are various business models for tech companies, the focus areas of tech due diligence providers can also vary.
Recommendations for action for companies ready to sell
Companies can and should do several things to prepare for and support technical due diligence as part of their sales process. Because it is in the interest of both parties to ensure that the process goes smoothly.
The most important recommendation: Involve your CTO in the sales process as early as possible. Ask them for an honest and detailed assessment of the company’s key areas in Tech DD: scalability, team, product, and technology.
Involve your CTO in business planning and clarify what investments, if any, are needed before an initial sales call and what tech changes need to be planned for in the future.
As the central point of contact in the Tech DD, your CTO should be able to answer questions competently. Leave nothing to chance and support your CTO in preparing for the conversation. Many CTOs are introverted and may have limited experience with reference situations in their careers. Therefore, coordinate the answers in advance and, if necessary, offer your CTO the opportunity for role-playing so that they can demonstrate the confident professionalism you want to see representing your company in the sales process.
Tech DD: key role in any negotiation process
At FLEX Capital, we look for healthy, profitable historical growth, the specific market environment, and the quality of the team when selecting our investments. However, this does not mean that we focus solely on the Commercial DD. Without a solid technological foundation, companies cannot achieve sustainable success today. Therefore, the Tech DD plays an important role in every transaction negotiation.
The results presented by the experts are compared with the company’s business plan: Are there enough costs allocated for technology? What are the risks associated with technological weaknesses? Can the risks be minimized through slightly higher investments, or is there a risk of business collapse? The outcome of our analysis can, in the worst case, result in a price adjustment or even the termination of negotiations. In the end, we stand by it: Technology must offer more than just a good first impression.