Our last article discussed some of the peculiarities of the software sector, and how they impact the priorities of commercial diligence on a software company vs. a target in a different space. In prior articles (Part I and Part II), we have also discussed the value of conducting diligence on a software company’s product and underlying technology. In this article, we explore some of the potential pitfalls and blind spots that investors may face if they do not adequately integrate the findings of these two work streams, and some of the opportunities when they do.
The benefits of integrating commercial and technology diligence extend far beyond vendor consolidation and potentially favorable pricing. For instance, when a technology diligence is integrated with a commercial diligence, it can inform the commercial diligence about a product’s ability to address new use cases or serve new customer segments, which can have meaningful implications on the size of the serviceable addressable market.
Likewise, a commercial diligence integrated with a technology diligence can ensure that the technology diligence appropriately prioritizes assessing key product attributes that impact purchasing decisions. In sum, an integrated diligence
provides an investor with greater confidence in the target’s ability to realize its financial projections, and the basis of a go-forward strategy.
This article explores five common scenarios that a software investor may face, and why an integrated diligence will better position them to make an informed investment decision.
1. Scalable Platform for Growth
Scenario: A software company has acquired several adjacent point solutions in recent years and now appears well-positioned to meet market demand for an end-to-end suite solution. Double-digit top line growth projections seem reasonable, and it is expected that the company will be able to leverage cost efficiencies to improve margin, though the details of the profitability projections are not entirely transparent.
The high fixed, low variable cost model typical in the software sector heavily favors scale players: superior market share results in higher margins and greater ability to invest in out-innovating the competition, creating a virtuous cycle. However, this rule does not always apply, especially if companies under-invest in their product and the underlying infrastructure required to support growth.
A technology diligence can assess aspects of the product that are not visible to the customer base and market but which can have substantial longer-term impacts on performance and scalability. These include whether the product is well-architected, whether it has a fit-for-purpose technology stack, and the amount of outstanding technical debt (maintenance work required to keep a software system up-to-date that does not include upgrading or adding to functionality).
By tightly integrating the commercial diligence with the technology diligence, the effort can quickly narrow in on the most attractive commercial opportunities and then assess whether the target has the technology and capabilities necessary to exploit these opportunities. For instance, in larger software organizations and those that have grown through acquisition, it is not uncommon for different technology stacks to be used for different products. A commercial diligence alone can assess the value of further integrating multiple products into a suite solution. But when integrated with a technology diligence, we can then assess the amount of investment required to undertake these integrations, and whether the architecture and technology stack are sufficiently coherent and scalable. If the diligences are conducted as two independent work streams, the commercial diligence will likely not uncover the technical feasibility of pursuing growth opportunities, and the technology diligence may not identify the highest-priority technology requirements to enable growth.
2. Functionality Differentiators and Shortcomings
Scenario: A software company has taken the mid-market by storm with its easy-to-use SaaS offering and now has the enterprise market firmly in its sights. While the company’s management team insists that it has built out the more complex capabilities required to serve enterprise customers, the market still perceives the company to be a mid-market player unable to compete effectively with the established on-premises enterprise players.
This scenario will not be uncommon to many software investors, representing potentially high rewards but with a high degree of risk. Commercial diligence can effectively identify which capabilities drive purchasing decisions across customer segments, but market perception of the various vendors tends to lag reality, and so it can be challenging to measure the existence and impact of new product features through market research alone. Similarly, an independent technology diligence may not identify that a certain feature is differentiated in the market, or that addressing a functionality gap is critical to penetrating a particular segment.
While standalone diligences may fail to distinguish between secret sauce and marketing perception, a technology diligence conducted in parallel with the commercial diligence, and informed by insights around key purchasing criteria and market perceptions of the target’s differentiators and shortcomings, can give an investor a far more accurate picture of how well the company is positioned to meet the current and future needs of the various customer segments.
Scenario: Commercial diligence has identified a large addressable market in the SMB segment. While the target company’s lack of traction has been attributed to insufficient focus on go-to-market strategy, it is challenging to determine whether the company could profitably serve this segment.
Investment theses are often underpinned by the ability to expand a company’s addressable market – whether it be through moving up-market or down-market, extending into new geographies, capturing a greater share of workflow and wallet, or adding new user personas and use cases. A commercial diligence can effectively assess and quantify the addressable market, and determine the product requirements to address each segment – but it alone may fall short on determining whether a segment is serviceable by the existing product. This requires answering questions on product adaptability, such as: Does the target’s product have the cost structure to move down-market? The robustness and configurability to move up-market? The flexibility to build in new use cases?
An integrated commercial and technology diligence can determine the most attractive segments to pursue, identify whether these segments are serviceable by the product today, and quantify the product investment required to service each segment.
4. SaaS Capabilities
Scenario: A founder-owned software company participates in a market ripe for SaaS disruption, yet is still on a perpetual license plus maintenance pricing model. The financial implications of a full SaaS transformation are evident, but the technical constraints are less clear.
SaaS transformation can be an attractive opportunity for software investors to pursue. While founder owners often favor the short-term cash flow benefits of license revenue, migrating to a recurring revenue stream via a subscription model can be an effective way for an investor to increase exit multiples. However, it is critical to understand both the market appetite for a SaaS model and the technical feasibility.
A commercial diligence can assist with the former. It can assess current SaaS adoption, the drivers of adoption (e.g., scalability, preference for opex vs. capex, need for remote access), the barriers to adoption (e.g., security concerns, preference for self-managed upgrades), the outlook for SaaS adoption by segment, and the state of the competitive landscape. To answer the latter requires an assessment of the underlying technology to understand the current state (e.g., extent of multi-tenancy, if any) and the effort and investment required to migrate to a truly single-instance SaaS model.
An integrated diligence is able to combine these two perspectives in order to support the business case and build the foundations of a SaaS transformation strategy. For instance, a software product that is focused on the enterprise market might not require a multi-tenant architecture, but the SMB segment may remain unaddressable without multi-tenancy due to the high overhead of dedicating hardware to every customer. Developing the right strategy for this scenario requires simultaneously understanding both the market opportunities and technical requirements.
5. Product Roadmap
Scenario: The CIM presents a compelling growth plan based upon extending the core product into new use cases. The question is: can the management team execute on its plan?
Growth projections often depend on enhancements or extensions to the existing product line, and therefore assessing the feasibility of the product roadmap – and whether the underlying investment assumptions are reasonable – must be key diligence questions.
While a commercial diligence can assess whether a product roadmap includes the functionality improvements required to win in core markets and pursue new markets, only a technology diligence can evaluate questions such as: Is the roadmap feasible within the targeted timeframe, given the existing software development processes and governance? Does the existing architecture and technology stack support the slated product improvements? Does the roadmap budget for an appropriate level of technical debt remediation / infrastructure enhancements?
An integrated commercial and technology diligence can give an investor confidence both that the product strategy is aligned with the market opportunity, and that the company has the required talent, processes, tools, and technology to successfully execute on the product roadmap. By bringing these two crucial areas of insight together, an integrated diligence can form the basis of the go-forward strategy.
The software sector continues to evolve rapidly: point solutions are being displaced by suites in many spaces, SaaS is revolutionizing both delivery and pricing models, and the lines between software and services are growing fuzzier. In the face of these dynamics, investors are conducting increasingly extensive diligence on software targets, both in terms of commercial outlook and underlying technology. Tightly integrating these diligence work streams can give an investor a competitive edge in this hot deal market. By leveraging insights from each work stream to prioritize the other’s focus areas, and by consolidating findings into a set of actionable recommendations, an integrated diligence can give an investor greater confidence in the target’s ability to realize its financial projections, drive rapidly to the heart of the value creation opportunity, and provide the basis of a go-forward strategy.
by Edward Plummer, Director in the Strategy Consulting practice