What You’re Missing When You Skimp on Tech Diligence

Throughout my career I have led hundreds of diligence assignments, first as a CTO and Corpdev exec, then as a venture investor, and most recently as co-head of a software-focused strategy consulting practice. While this work has covered all facets of diligence, a majority of these assignments have been product and technology focused. But what continues to surprise me, even in the tech sector, is the number of deals we see going down without sufficient product and technology diligence. In this article we explore the risks investors and buyers are taking by skimping or skipping this fundamental input into investment and acquisition decision making.

Product – does it compete for new business or just satisfy existing customers?

Many investors and acquirers, particularly those of later stage companies, settle for using customer diligence as a proxy for product diligence. While customer diligence will reveal evidence of customer satisfaction, it is not sufficient for validating product differentiation. This is because in many software sectors customers can easily be “satisfied” with less than superior products.The more sticky the software or service, the less sufficient these tests are for product assessment. The stickiest software products are only evaluated to be replaced every 10-15 years, while the least sticky could be replaced every quarter. ERP systems tend to be amongst the stickiest types of systems. Lightweight services such as some marketing analytics platforms tend to be the least sticky.Sticky systems can create the illusion that customers love the products as well as the impression that the products compete well in the marketplace, when in fact customers are just scared of the time and cost of switching, so they don’t. Customers are likely to respond to a survey saying “no intention to replace the software” or “the product meets our needs” even when a product is no longer the market leader that it may have been when it was first purchased. Feature stagnation hidden by inadequate diligence limits the potential of the product to compete for new business, as the CEO of a company recently acquired by a PE firm experienced:

“Our products competed well within our customer base and we had reasonably strong customer satisfaction, but we couldn’t drive any growth outside of the base whatsoever. We failed to identify the technology’s inability to address changing market characteristics in our diligence.” – CEO of a New PE Platform Company

 

Roadmap – are the specs aimed towards what customers asked for, or towards where the market is heading?

The second area that escapes scrutiny more often than not is the product roadmap. The product roadmap is management’s plan for what capabilities are going to roll out in the products and in approximately what timeframes. It is often this vision that management claims will drive future growth.There are two pitfalls with the roadmap often encountered when diligence isn’t sufficient. The first is whether the roadmap is truly aligned not only with the market drivers but also with the buyer’s emerging investment thesis. It takes special skills and experience to be able to craft a roadmap to capitalize on market drivers as well as defend against market headwinds and competitive pressures. As Wayne Gretzky often said – you want to be where the puck is going, not where it has been. Assessing this alignment is crucial to quantifying the product’s ability to deliver growth for the organization.The second common issue is related to the Profit and Loss Statement (P&L). It is extremely common for management to put forth a roadmap that is designed to drive growth and is aggressive in nature. It is rare, however, that management’s prospective P&L actually accounts for all of the expense over the requisite amount of time to deliver on that roadmap. And it is even rarer that management fesses up to the risks associated with the development efforts. The more aggressive the features and capabilities, the more risks there are in delivering them.Management can be squeamish about asking the difficult but necessary questions when designing the product roadmap, such as these: Does the team have adequate talent? Are their short term priorities (like closing existing sales) that will distract the team from the capabilities on the roadmap? Will rapidly changing market requirements warrant constant re-evaluation of the roadmap and make it difficult to deliver anything that takes more than 24 months of planning and execution? Finally, does the roadmap and development plan align with the newly emerging investment thesis (spend and grow, harvest profits, buy then build, etc.)? The consequences of a roadmap that doesn’t address the relevant dynamics can be fatal, as this PE investor learned the hard way:

“The company was adequately building what its existing base of customers were asking for, but there was little attention to changing market segmentation and trends. As a result 4 years later the company flattened out, just as we were getting ready to sell it” – PE General Partner

 

Architecture – how much does technical debt matter?

Technical Debt is the off-balance-sheet liabilities a company has that represent the implied costs and obligations associated with fixing or rewriting parts of a software system. These fixes and rewrites are inevitable when the current system isn’t capable of moving forward too far into the future without these issues being addressed. Studies such as the Cast Report have estimated technical debt to be in the range of $3-5 per line of code in most systems. This may seem trivial until you consider that most significant software systems are comprised of millions of lines of code, if not tens of millions.Needless to say, it should be clear why identifying these liabilities should be critical to investors and acquirers. A buyer would never acquire a company without a full understanding of the balance sheet, including the liabilities. It should follow that important off-balance-sheet liabilities are equally as important, and thus should not be ignored.Even more importantly, these liabilities that can have an impact far greater than their current value. When technical debt isn’t well-understood, it tends to surprise development teams as well as management. These surprises lead not only to increased expenses and decreased profits, but also to product delays, lost revenue, and a weakening of competitive positioning. Significant value can be lost, and value creation opportunities missed, due to the failure to identify technical debt up-front.We recently heard this from an investor:

“We were caught by surprise after we invested as the product was harder to implement and deploy than we were told, and the new products demonstrated to us during diligence were far from complete. This put us at least 1-2 years and millions of dollars behind the plans laid out in our investment memo.” – PE Principal

 

Organization and Talent – what about post transaction brain drain?

Limited diligence on the R&D organization and its processes is understandable. Sellers don’t want buyers digging deep inside the part of the organization that houses the crown jewels. Sellers want to protect the valuables until the majority of diligence is done and the deal is a sure thing. They also might want to protect from findings that could impair value (finding too much technical debt, etc.), and/or protect the talent from being recruited should the deal not close.Buyers often agree to these approaches as it also allows them to avoid the need of bringing larger parts of their own organizations into the diligence process. The result is often an acquisition with limited visibility into how well an R&D organization can support the investment thesis of the buyer. But many come to regret this approach, like this investor did:

“Right after we invested we had a talent drain, and as a result the R&D organization fell behind on the roadmap and ran behind plan for the next two years. The remaining leadership was not capable or driven enough to attract the talent that was needed to adequately advance the product in a manner that was required.”- PE Operating Partner

 

Summary

Without acknowledging the numerous risks of ineffective diligence efforts, many investors choose to go without proper diligence. Recent heat in the M&A and PE markets haven’t helped the situation. Limited diligence windows along with increased pressure to deploy capital have led to even more cases of quick and dirty diligence. But it is during times like this, when valuation multiples are close to all-time highs, that buyers and investors need to be extra prudent and make sure their acquisitions and investments will accrete value sufficient to overcome any future market corrections. The best way to do that is with robust product and tech diligence.[Contributed by Jeffrey Vogel, Strategy Consulting]

Posted on May 15, 2015 in Insights, Private Equity, Technology Industry