Previously published by Forbes on June 20, 2022
In the excitement of having signed a term sheet, investors may be tempted to consider technical due diligence (tech DD) as a formality to assuage their colleagues and limited partners. Tech DD, however, should be considered more than a defensive tool to avoid embarrassment and the loss of the money invested.
Tech DD, when performed correctly, can limit risk and ultimately increase an investment’s return by laying out the technology milestones critical to the success of the business. With proper tech DD, investors gain agency, and thus peace of mind, in shepherding a company’s growth.
While situations such as Theranos or WeWork are extreme, my organization has encountered “unexpected” situations in the course of tech DD projects, such as:
• A company running tens of thousands of users on the Ruby-on-Rails code that it demoed for its seed round.
• A company where the code had yet to be written for a large proportion of the advertised functionality.
• A founder/CTO who had reached his/her limit of expertise and was unlikely to be the right person to lead the company in its next stage of growth.
• A company with large amounts of legacy code running core functionality without any of the engineers who wrote the code still working for the company.
Being alerted to the scenarios above, along with the estimates of the time and effort required to put the company on a solid footing for scaling, allowed the investors to rebase the financial projections with more realistic time frames.
Seven Crucial Questions For Tech DD
None of the scenarios are intrinsically deal killers, yet they likely warrant action from investors pre- or post-investment. These, and countless other scenarios like them, can often be missed if tech DD is treated as a “check-the-box” exercise. In order to limit the risk of investments, as well as provide visibility on deliverables over the next couple of years, the following questions have proven to be particularly important:
1. How reliable is the delivery schedule of the product road map? Delays in the product road map are indicators of delayed revenues since delayed features make it harder to attract new customers. In addition, the efficiency of product and engineering in managing the product road map and the associated release schedule is critical to the overall development velocity of the company.
2. Will the technology handle the user growth over the next couple of years (taking into account the technology upgrades on the road map)? Has the technology team properly scoped the complexity, time and effort for the refactoring or re-architecting needed to reach the projected scale?
3. Are non-customer-facing aspects of technology aligned with the maturity, size and market of the company? Companies in high-growth mode can easily lose track of the product’s security, resiliency and business continuity. Similarly, it is difficult to ensure that tools and processes for QA, CI/CD, operations are upgraded in line with growth.
4. Does the tech team have a plan to maintain its velocity while scaling? This question should go beyond the software architecture and addresses how and when organization, tools, processes and metrics will adapt in engineering and operations.
5. Does a new CTO need to be hired (or other technical leaders)? Is the technology leadership team ready for the next phase? How well have they mapped out the next big set of projects?
6. Are all the technology projects in the budget? Do they have the proper funding, staffing and time estimates?
7. Does the company have uniquely differentiated intellectual property? Intellectual property is rarely about patents. Rather, investors want to know whether the company has built a “defensible competitive moat” through market research, unique use of available technologies, proprietary technology or algorithms (e.g., for data science or machine learning).
How Investors Can Leverage Tech DD Findings
The benefits to investors who embrace the tech DD process outlined above materialize in the form of one evaluation and two numbers.
• The ultimate evaluation is that of risk. Has the riskiness of the investment increased dramatically? It’s crucial to understand whether the investor will need to be more involved than planned in monitoring how well the company executes or possibly spend time supporting the management team.
• The first set of numbers is the quarterly revenue projections, and whether they need to be adjusted based on the information received during the review. A delay in features, or scalability, will likely delay revenues and thus ultimately the value of the company. In the worst case, the company could lose out to a more nimble competitor.
• The second number is the amount to be invested in the company. Does this number need to be adjusted to account for delayed revenues, increased costs from a larger than planned technology team or unanticipated development?
An important additional benefit of this effort occurs when investors review the tech DD findings with the company’s management team and align expectations. This reduces the likelihood of unpleasant surprises post-investment.
In terms of deliverables, investors should expect an overall assessment of the technology and the technical team’s ability to deliver the features, customer-facing and not, that underlie the product road map and thus the revenue projections.
Whether this assessment matches their own will determine whether their risk projection for the deal needs to be adjusted. In addition, investors should receive a quarter-by-quarter list of technology deliverables that are critical to the success of the company. With this information, investors improve the odds of the company meeting its plan by taking actions early, in collaboration with the company, to set it up on a path to success.