The importance of Technology Due Diligence for investors
The missing piece of modern M&A due diligence.
A case for more robust technology due diligence, part of the M&A process, to ensure investors understand the technology maturity and required investment to maximise investment ROI.
When investors are assessing the valuation of a business, they look at the current success (proven financial track record) and at the future potential (growth forecast). In traditional industries, normal financial and corporate due diligence can give the investor the information required to be confident about that future potential and thus develop a credible valuation.
For technology businesses, whether that’s B2B SaaS companies or consumer apps & solutions, this becomes a lot more complex. The pace of change and innovation is fast, competition usually fierce and in most segments there is a limit to the number of businesses who will ultimately reach scale, and succeed in dominating a product niche category. This has resulted in a high risk, high return image for technology investing, where if you can pick the right team & product, high valuation multiples and high returns for investors are within reach. However, for every technology unicorn there are 100 failed tech startups that don’t go beyond seed funding, or series A, and are far from reaching sustainable scale and profit.
There are many public cases where even leading investors have either not done sufficient due diligence or were defrauded / misled by companies and founders (which might have been avoided with the right level of due diligence). The most famous example is probably Theranos, where Elizabeth Holmes defrauded investors of $700m with the promise of its so-called revolutionary technology to carry out multiple blood tests using small blood samples. I wonder how investors were so easily swayed to fund the business without seeing the evidence of a functioning technology. Other examples include student aid platform, Frank, bought by JP Morgan Chase, where it became clear after the acquisition was completed that the majority of users were fake to drive up the valuation. It’s the fraudulent ones that make headlines but for the majority of technology startups and scaleups who fail, it’s because the technology was not differentiating enough or the technology team was not able to keep up with the pace of innovation required to succeed.
Early inflation of the future potential of a technology solution is a risky but necessary strategy for technology startups. When done well, it can help startups raise the necessary funding to get off the ground and grow. However, when done poorly, it can lead to unrealistic expectations and investor disappointment.
It is important for investors and founders to have a clear conversation about the future potential of a technology solution, but also its gaps. Founders should be honest about where their company is in its journey and what actions they are taking to achieve their goals. Investors should be realistic about their expectations and be prepared to invest in a company that is still in its early stages.
In the current investment climate, where the era of “costless capital” has come to an end, the pressure on VC valuations will continue to present a challenge for investors to hedge their risks. The days of easy wins fuelled by multiple expansion and high leverage are probably over in PE, and asset managers are going to have to work harder for their returns both by identifying the right opportunities to invest and then be more active in helping those businesses in executing the future potential.
What can investors do to mitigate some of that risk? By doing proper technology due diligence and providing technology support to their portfolio companies.
What is technology due diligence?
Technology due diligence helps to evaluate the maturity of the technology solution to support the overall business valuation and future strategy. It helps to:
Assess the technical capabilities of the company, its products and its team
Evaluate the market fit and potential for growth
Identifies and assesses technical and operational risks
Reviews the level of competition and market saturation
Validates the technology sophistication and IP ownership
By conducting thorough technology due diligence, investors can make more informed investment decisions and minimise their risk exposure. Regular reviews ensure progress is made over time and required changes to the technology strategy are anticipated early, before disruption happens.
How are investors managing the uncertainty? Some are looking to bolster their teams with technology experts. However, it’s hard to get value from a generalist as technology is broad. Deep expertise across a variety of technology topics is required to make the right decisions. The better approach is to partner with a broad set of advisors or find a partner that can unpack the technology due diligence and bring the right capabilities and expertise together to get the right outcome.
At Tightrope, we partner with investors and scale-ups to help reach the next horizon of growth with confidence. This includes reviewing the technology maturity of the business and guiding the investor in their investment decision and strategy forward.
Our 10 step Technology Due Diligence approach
In working with a variety of technology businesses over the past few years, we’ve developed our own detailed Technology Due Diligence framework to ensure we cover all the basics. This process provides a very clear picture of the value of the technology components of the business. It maps out the current maturity of the technology solution, the team, data, security and ways of working to give confidence to investors and owners not only to invest but also understand where to potentially spend time and money to further improve things as the business scales.
The 10 “chapters” of our technology due diligence are structured in a logical way so they tell a story to the reviewer.
Solution Overview: The most business focused section. We review what purpose the technology has, the solution it provides to customers (B2B or B2C) and how it does this in a unique, differentiated way. Through product demos we explore how the product works. We review how customer are paying for access to the solution (business model) and how value is provided (different features / versions for different customer types with matching tiered pricing). In this section, we also review how the solutions is broken down and how it is managed by the organisation. We review the sophistication of the solution, the key components of the solution, the differentiation vs. competitors, what’s done in house vs. external and how customers are using the product. The insight in how customers are using the product is key - we typically interview 2-3 existing customers to understand how the customers are using the product matches the way it was intended to be used. Does the product deliver on its promise to the customer + what makes it sticky in the customer’s operations to assess the churn risk of customers. Great technology products are differentiated, solve a customer pain point, are highly embedded by users into their BAU operation, and supported by a tiered subscription model that drives recurring annual revenue.
Technology Architecture: Breaking down the solution into it’s core technology components. In this section we understand how the product does what it does. We try to get a view on how unique and sophisticated the technology works to deliver the outcomes for the customer. A typical digital solution will have a number of core components:
Front end: the user interface - what the customer is using to interact with the product. It brings together the data, computing power, any backend AI etc into the clean layer that users can easily navigate. This can be through a web browser, an app or a specific software front end. This typically includes reporting layers that help present the data in user friendly way.
Middle Layer: Usually where the magic happens. It’s where the data is combined and transformed into useful insights presented in the front end. This houses the computing power to run (AI) algorithms and any other manipulation of source information.
Back end: the infrastructure on which the solution runs. This is typically some cloud or server infrastructure, with data lakes that hold databases of key data and documentation.
Integrations: In this section, we review the integrations with other systems, both upstream and downstream. We evaluate if the integrations are well defined, documented, and secure. Additionally, we assess the complexity of the integrations and if there are any potential issues in case of changes in any of the integrated systems. If any open source integrations are used we review if the right strategy for using open source is in place.
Security & Performance: We evaluate the overall security of the solution, including data protection, access control, and disaster recovery plans. We also review the performance of the solution and assess if it meets the expected requirements and scalability needs. We review how this is shared and communicated to customers through SLAs and dashboards.
Testing, Documentation & Audits: We review the testing procedures, documentation, and any audits that have been conducted on the technology solution. This helps to identify any potential gaps in quality control, and ensure that all necessary documentation is in place for future reference.
Code Health: In this section, we review the overall health of the codebase. This includes assessing the code quality and complexity, evaluating the use of coding best practices, and identifying any technical debt or other issues that may impact the scalability and maintainability of the technology solution.
Data: We review the data architecture, data quality, and data management practices to ensure that the technology solution is capable of processing and managing data effectively and efficiently. We also review the data security. Are there back-ups in place and is data stored compliant to local regulations?
Team & Capability maturity: In this section, we review the team responsible for developing and maintaining the technology solution. We assess their capabilities, experience and tenure, and the overall maturity of the team to ensure that they can support the solution over the long term.
Change Management and Ways of working: We review the change management processes and ways of working to ensure that the technology solution can adapt to changing business requirements and that any changes are managed effectively. What does the team have in place to manage the execution of the solution roadmap, with ad-hoc changes based on customer feedback and any defect fixes that might occur.
Technology Strategy and Development/Product Roadmap: Finally, we review the technology strategy and development roadmap to assess the potential for future development and growth of the technology solution. This includes evaluating the technology stack, any potential technology risks, and the overall alignment of the technology solution with the business strategy.
We ensure that the technology due diligence process covers all the critical components of the solution and provides a comprehensive view of the technology maturity and potential risks. By doing so, investors can make informed decisions and maximise their investment ROI.
Our rapid technology due diligence only takes a few weeks and gives that required view of the maturity of the solutions. If a more detailed under the hood review is required, our 6-7 week detailed technology due diligence leaves no stone uncovered and gives the technology team a solid set of recommendations to take the next step towards a more scalable technology product.