Entering into a merger or acquisition agreement without thorough research into a company’s finances and operations would be unthinkable.
An M&A deal is the biggest corporate transaction companies make, says the team at DealRoom, and due diligence allows them to proceed from an informed standpoint. “It can add significant value for the buyer by showing where the target company’s weaknesses (or red flags) are as well as identifying some opportunities within the target company that it previously wasn’t aware that existed.”
Yet even the most thorough pre-acquisition research often overlooks a key aspect of the target company: its technical health.
Technical due diligence analyzes and evaluates a target company’s technology, software architecture, people and processes. It allows acquiring companies to evaluate risks related to IT and confirm whether growth targets are reasonable given the company’s technological infrastructure.
In this article, we’ll look at the growing importance of technical due diligence, what technical due diligence looks like and why it’s worth the investment.
Technical Due Diligence Is More Important Than Ever
Technical due diligence is already critical to the success of M&A deals, and its importance will only grow as IT and software become even more essential to a company’s operations.
This can be seen in the way companies are investing in IT. Despite recession fears, companies are giving priority to IT spending. According to research by Spiceworks Ziff Davis, more than half of organizations plan to increase IT budgets in 2023.
“Technology can be a differentiator because it’s at the heart of most organisations,” says Thomas Lemon, managing director at Protiviti. As such, technical due diligence is needed to understand what risks exist now, what risks could emerge and how they can be mitigated. “That type of work is becoming more key to a transaction’s success or failure.”
Despite this, most companies aren’t yet investing in thorough technical due diligence. In the private equity market, for instance, Bain’s Hank Chen, Jonny Holliday and Robert Pierce write that “too many private equity investors still view technology due diligence as a check-the-box exercise or fail to integrate it into a holistic effort to assess risk and underwrite value” — even though nearly a third of those deals are for tech companies.
Put another way, far too many investors enter deals without actually understanding what the company they’re buying can do.
What Does Technical Due Diligence Look Like?
It’s important to outline what the technical due diligence process looks like and what clients can expect when using a company like Kingsmen Software to carry it out.
First, technical due diligence should never be a check-the-box exercise. Rather, it should take the form of a thorough assessment of the maturity of a company’s people, process and tools as they relate to technology, says Bill Clerici, CEO and Partner at Kingsmen Software.
That process should culminate in a report that scores the company on a multitude of metrics, highlights immediate risks and provides a roadmap for future growth.
A technical due diligence report should cover every aspect of a company’s technical infrastructure and application lifecycle management, too. For reference, a Kingsmen assessment covers the following areas:
- Version control. Does the company have full traceability of projects from requirements to code in production? Can everything be rolled back to a previous version?
- User experience management. How are the end user’s needs taken into account?
- Program and project management. What is the process for managing projects?
- Requirements management. What is the process for breaking down development work?
- Architecture and design. What does the system’s architecture look like, and is there a process for modeling?
- Application development. How does the development team function? Are there style guidelines, quality checks, acceptance criteria and automation?
- Project portfolio management. Do you have a process to understand what’s coming down the road? How does it get prioritized?
- Work item management. Do teams have processes to break down requests into manageable tasks?
- Quality management. Are there processes in place to manage software quality?
- Test defect management. Is there an automated strategy in place to test code and new releases?
- Release management. What is the process of planning new releases?
What Does Technical Due Diligence Achieve?
Whether you want to identify the potential for growth in a target company, highlight potential risks or put yourself in a better place to negotiate, technical due diligence will support those goals.
It Identifies Potential Risks
There’s an element of risk to every M&A acquisition, but technical due diligence can minimize the risk of IT-related issues as much as possible.
Those risks can be both common and large. Given the critical role technology plays in business operations, a single issue can have the potential to sink the business or delay growth. That risk could come in the form of security and compliance issues, outdated infrastructure, or poor code quality. In any case, those risks can bring financial and reputational repercussions.
Technical due diligence will uncover and rate any potential risks facing the purchasing company, as well as provide an idea of how they can be resolved. As a result, buyers can get the peace of mind they need to make a deal knowing that risks have been identified.
It Helps You Clarify Your Growth Objectives
Leveraging a company’s technological abilities is one of the easiest ways to scale it. But there needs to be existing infrastructure and processes to achieve that growth. Technical due diligence will find out if that’s the case.
Most people will say due diligence is about hoping one party gets the best deal, writes PitchBook’s Adam Putz. And while that answer is correct to a degree, the due diligence process is mainly used to understand the operations of the acquisition targets. Specifically, “the due diligence process helps understand synergies, potential scalability of the business with enhanced operations and more access to customers from the buyer's company.”
If technical due diligence reveals underlying issues with a company’s infrastructure, for example, then further investments will be necessary before the company can scale.
It Helps You Better Negotiate With the Seller
Ultimately, technical due diligence puts you in a much stronger negotiating position.
“Issues that are uncovered during the due diligence process might impact the purchase price or the representations and warranties the buyer requests from the seller in the purchase agreement,” Wyrick Robbins attorneys Christie A. Hartinger and David P. Creekman write.
Often, selling companies don’t have a strong grasp of their own tech infrastructure. As a result, they can significantly overvalue or undervalue it. Technical due diligence brings clarity to that aspect of the deal.
Entering Negotiations? Invest in Technical Due Diligence
When technology is a fundamental part of the modern organization and a key pillar of growth, it’s vital for investors to fully analyze a company’s technological maturity before committing to a deal.
Only thorough technical due diligence can fully uncover the risks and growth potential of a target company and put buyers in the best position to make a significant return on their investment.