What is a technology due diligence?
Technology Due Diligence (Tech DD) is a thorough analysis of a company’s technology platform, designed to assess its ability to support management’s and investors’ growth plans over the typical investment cycle of 5-7 years.
The Tech DD also plays a crucial role in ensuring that the investment remains attractive to the next owner, whether that's another private equity firm or an industrial buyer.
The Tech DD results in a detailed report that serves as a foundational tool for making informed investment decisions. It’s particularly crucial for companies offering software products or tech-enabled services.
Tech vs. IT Due Diligence
Don’t confuse it with its cousin: the Information Technology Due Diligence (IT DD). While the Tech DD focuses on the core product technology, an IT DD centers on the business application landscape.
What are the core elements of a Tech Due diligence?
The Tech Due Diligence can be boiled down to the three core elements of a modern tech company: Product, Organization, and Process, as outlined in the illustration below.
Product
Evaluation of the core product: architecture and technology, product strategy and roadmap, and security and compliance posture.
Process
Assessment of key tech processes: development, product management, customer support and customer onboarding.
Organization
Analysis of the tech team: examining size, structure, skills, talent sourcing strategies, and assessing potential key man risk.
What Questions Does a Tech Due Diligence Answer?
The Tech Due Diligence should help investors answer four fundamental questions about the tech platform: Can it Scale and is it Competitive, Secure, and Efficient?
-
1 | Scalable
Can the tech platform scale in line with the company’s growth plans? Ensuring scalability is essential for supporting future expansion and avoiding bottlenecks as the business grows.
-
2 | Competitive
Have key technologies and customer needs been adequately addressed? This focuses on whether the platform is equipped to maintain a competitive edge in the market by leveraging the latest technologies and meeting customer demands.
-
3 | Secure
Are security risks known and proactively addressed? Security is a critical concern, and this aspect ensures that potential vulnerabilities are identified and mitigated to protect the company’s assets and reputation.
-
4 | Efficent
Is the development organization efficient and effective? Efficiency in development processes and organizational effectiveness are key to maintaining productivity and delivering quality products on time.
What are the Main Due Diligence types?
-
Evaluate technology platform's ability to support management's strategy and growth objectives. Red flags may include lack of scalability in core software offerings, inability to meet modern security and compliance standards, or limited adaptability to future technological advancements and innovation needs.
-
Assess the quality of earnings at the category, product, market segment, and country levels to fully understand growth and profitability. Red flags to watch for include stalling growth, increasing customer churn, or declining profitability in key product categories, which may indicate deeper financial issues.
-
Evaluate market attractiveness and competitive positioning. Red flags may include low growth in key markets, insufficient entry barriers, or underperformance in meeting customers' key purchasing criteria compared to competitors. Consider impacts of changing market trends and customer demands.
-
Understand company's rights, obligations, and intellectual property ownership. Assess regulatory compliance and potential legal liabilities. Red flags may include unresolved lawsuits, unclear IP ownership, or contractual disputes with customers or suppliers that could impact operations or valuation.
-
Other types of due diligences that may be conducted depending on the situation are HR, sustainability, pensions, tax or key areas of operations such as manufacturing or sales.
Buy-Side Tech
Due Diligence:
Performed to minimize investment risk and ensure that management’s plans and investment hypotheses are achievable. It also helps investors gain a deeper understanding of the industry, the target company, and its competitors, potentially uncovering opportunities for value creation through M&A or additional product development.
Sell-Side Tech Due Diligence (Vendor Due Diligence or VDD)
Conducted by the selling company to prepare for a transaction. A tech VDD identifies potential dealbreakers, streamlines the transaction process, and enhances credibility with potential buyers. It mitigates risk and showcases the company’s strengths, providing peace of mind to management and current investors by ensuring all potential issues have been identified and addressed.
Tech due diligence is undeniably crucial, particularly for tech companies, but it can also be vital for traditional businesses. For instance, if a company’s IT platform is outdated, resulting in inefficiencies in areas like finance, supply chain, or eCommerce, the cost and resource demands of modernization projects could significantly impact the company’s growth potential.
In order to answer these overarching questions, advisors analyze the target company in up to 20 areas of the tech platform, such as software architecture, infrastructure technology, software development lifecycle, and the tech organization’s skills and tenure.
FoT’s proprietary tech due diligence methodology, TechCheck, provides a comprehensive assessment, ensuring that the technology platform is robust across these four key dimensions.
Key Outputs of a Tech Due Diligence Report
The primary objective of a tech due diligence report is to identify any major risks that could impact the competitiveness of the company or its ability to execute the business plan. The report typically includes a list of recommended projects to mitigate these risks and improve the technology platform, along with estimated costs and effort required for implementation. Additionally, the report provides a maturity rating for each element of the technology, benchmarking it against industry standards—categorizing it as a laggard, on par, or ahead of the curve.
Beyond risk identification, tech due diligence offers investors valuable insights into the technology, the company, and the industry. This understanding can be instrumental in identifying opportunities to enhance the value of the acquisition. Investors often have specific questions or concerns, and these are addressed during the due diligence process to ensure a thorough evaluation.
How to Prepare for Tech Due Diligence
If your company will be subject to a tech due diligence, proper preparation is crucial. Investors will request detailed data and will likely require meetings with your team, potentially lasting a full day. Anything shorter than half a day may leave tech due diligence advisors uncertain about their findings, unless a comprehensive sell-side report has already been prepared—in which case, a one-hour Q&A session alongside management presentations on the product and technology may suffice.
Key Preparations
Assemble a team of 2-3 knowledgeable individuals who can organize documentation, present effectively, and include key executives. It’s important to initiate preparations discreetly.
Team
A weak product demonstration can be detrimental. Ensure that you have a skilled demonstrator who can showcase the main use cases from a user perspective. During the demo, highlight what makes your product unique and why it’s preferred over competitors.
Demo
Take control of the agenda. Structure your presentation logically, share detailed information, include data and proof points, and highlight your achievements.
Agenda
Typically, there is no need to share source code unless specifically requested by the investor for a good reason. However, having security audits prepared is strongly recommended, and it’s best to conduct these well in advance to give time for any mitigation required. In our article “Source Code Analysis: When Should Investors Press For It?” we outline the four situations investors usually push for access to the source code before committing to a deal.
One potential complication of Tech/IT Due Diligence is that it’s typically brief, often just two weeks, and sometimes left as a final step before finalizing the transaction. By this stage, the buyer and seller generally have a strong mutual understanding of the price and terms.
This phase is critical, as any negative findings could prompt investors to renegotiate the price or even withdraw from the deal, potentially squandering significant time and resources already invested.
Another challenge is that tech due diligence may require the involvement of additional personnel from the target company to provide detailed information. This can lead to several issues, such as increasing the risk of information leakage or subpar quality due to stress and lack of time for preparations if they are scrambled at the very last minute.
For more detailed guidance, we offer a comprehensive guide to preparing for tech due diligence, which can significantly assist you in the process.
What to Look for in a Tech Due Diligence Team
A top-tier tech due diligence team should be led by experienced CTOs who have not only built complex software products but also successfully scaled tech companies multiple times. These experts bring real-world experience to the table, speaking the language of developers and engaging effectively with CTOs and CEOs on tech strategy. They offer pragmatic insights, understanding the trade-offs necessary to make a tech company successful.
To ensure thorough and efficient assessments, the team should be complemented by smart analysts who are IT generalists and expert project leaders. These professionals should have broad experience across the tech stack, excel at problem-solving, and be quick to analyze data, summarizing findings in a clear and accessible format.
A seasoned tech due diligence team brings the collective experience of over 100 transactions, enabling them to execute assignments confidently, even on short notice—sometimes within just a few days. What truly sets expert teams apart is their ability to work hands-on with the target’s tech management, establishing transparency with minimal reliance on data rooms.
They collaborate productively with the target’s experts, leaving them with the sense that they have been understood and respected. These teams can quickly adapt and probe during Q&A sessions, explain findings clearly to investors, and produce final reports that withstand scrutiny from the target’s management.
Additionally, it may be advantageous to employ a team capable of assessing the functional aspects of the target’s product and benchmarking it against the competition. This typically requires tech-savvy users with 10+ years of industry experience, familiar with various tools and intimately aware of the relevant business processes. Function of Tech (FoT) has extensive experience in recruiting and collaborating with industry experts across multiple sectors to conduct these assessments using our proprietary product benchmarking methodology.
