Managing Risk with Technical Due Diligence
You should not buy a home without an inspection by a licensed home inspector and you should not buy a used car without having a mechanic check it out for you. Diligence - it just makes good sense. Similarly, it is prudent to include technical diligence as part of the evaluation for a potential technology company investment.
Diligence Informs Risk Management
Private equity and venture capital firms typically evaluate many areas preceding a potential investment. The business case, legal structure, competitive analysis, product strategy, financial audits and contractual landscape are all examples of diligence deemed necessary prior to an investment. A company with a great product but three years left on an extremely expensive office lease will probably have a lower value. Breaking the lease or living with it until the term expires means higher costs and thus lower EBITDA. A hot start up with an inexperienced CFO that has run on cash-based accounting from day 1 and is rapidly approaching $6 million in annual revenue needs to move to accrual-based accounting. That takes time and effort and possibly a talent search - this affects the value of the investment.
But what about the technical underpinnings of the product itself? A company with a solitary production database and a marketing analyst with access to directly query that database is likely headed for performance and availability incidents. Single points of failure create a high probability of non-availability. Solutions that don’t allow for seamless and elastic scalability may run into either capacity or cost of operations problems.
Preventing these incidents and altering the conditions that enabled them to exist takes time and effort. All of these assessment areas boil down to risk management. Further, understanding the cost of fixing these solutions helps a company understand their true cost of investment. Your investment includes not just the “PIC” or capital that you put into the company - it also includes all the costs to ensure continuing operations of the product that enables that company. A comprehensive diligence including technical diligence will prepare the investor to make an informed business decision - know the risks and adjust the value proposition accordingly.
Technology Risk Areas
Technology risks can be grouped into four broad areas - Architecture, Process, Organization, and Security. Each area has several subordinate themes.
Architecture - subordinate themes are availability, scalability, cost control.
• Commodity hardware - Corollas, not Carreras
• Horizontal scalability - scale out, not up
• Design for monitoring - see issues before your customers do
• N+1 design - everything fails eventually
• Design for rollback - minimize the impairment
• Asynchronous design - stateless systems
Process - subordinate themes are engineering, operations, and problem management
• Product management - a product owner should be able add, delay, or deprecate features from an upcoming release
• Metrics - development teams should use effort estimation and velocity measurement metrics to monitor progress and performance
• Development practices - developers should conduct code reviews and be held accountable for unit testing
• Incident management - incidents should be logged with sufficient details for further follow up
• Post mortem - a structured process should be in place to review significant problems, assign action items, and track resolution
• PDLC - the Product Development Lifecycle should align with the company’s desires to be customer driven (not desirable in most cases) or market driven (resulting in the highest returns and fastest saturation of any market)
Organization - subordinate themes are PDLC (Product Development Lifecycle) structure, product alignment and team composition
• Product or Service Alignment - cross functional teams should be aligned by product or service and understand how their efforts complement business goals
• Agile or Waterfall - if “discovering” the market or choosing the best possible product for a market then Agile is appropriate - if developing to well defined contracts then waterfall may be necessary.
• Team composition - the engineer to QA tester ratio should ideally exceed 3.5:1. Significant deviations may be a sign or trouble or a harbinger of problems to come
• Goals - measurable goals aligned with business priorities should be visible to all with clear accountability
Security - subordinate themes are framework, prevention, detection and response
• Framework - use NIST, ISO, PCI or other regulatory standards to establish the framework for a security program. The standards do overlap, think it through and avoid duplication of effort.
• Policies in place - a sound security program will have multiple security related policies such as employee acceptable use, access controls, data classification, and an incident response plan.
• Security risk matrix - security risks should be graded by their impact, probability of occurrence, and controlling measures
• Business metrics - analysis of business metrics (revenue per minute, change of address, checkout value anomalies, file saves per minute, etc) can develop thresholds for alerting to a potential security incident. Over time, the analysis can inform prevention techniques.
• Response plan - a plan must be in place and must have regular rehearsals.
Technology Cost Impact on Investment Value
Technology costs can have a significant impact on the overall investment value. Strengths and weaknesses uncovered during a technical diligence effort help the investor make the best overall business decision.
Technology costs are normally captured in 2 areas of the income statement, cost of revenue (production environment and personnel) and operating expenses (software development). Technology costs can also affect depreciation (server capital purchases) and amortization (pre-paid licensing and support). These cost areas should be reviewed for unusual patterns or abnormally high or low spend rates. It is also important to understand the term of equipment purchase, software licensing, and support contracts - spend may be committed for several years.
Cost Cautions - tales from the past
• Support for production equipment purchased from a 3d party because the equipment is old and no longer supported by the OEM. Use equipment as long as possible, but don’t risk a production outage.
• Constant software vendor license audits - they will find revenue, but the technology team that leaves their company vulnerable on a recurring basis is likely to have other significant issues.
• Lack of an RFP or benchmarking process to periodically assess the cost effectiveness of hardware, software, hosting, and support vendors. Making a change in one of these areas is not simple, but the technology team should know how much they should pay before a change is better for the company.
A technical diligence effort should also identify the level of technical debt and quantify the amount of engineering resources dedicated to servicing the technical debt.
Technical debt is a conscious choice to take a shortcut in the technology arena - the delta between the desired or intended way and quicker way. The shortcut is usually taken for time to market reasons and is a sound business decision within reason. Technical debt is analogous in many ways to financial debt - a complete lack of it probably means missed business opportunities while an excess means disaster around the corner.
Just like financial debt, technical debt must be serviced, and it is serviced by the efforts of the engineering team - the same team developing the software. AKF recommends 12% to 25% of engineering effort be spent servicing technical debt. Whether that resource allocation keeps the debt static, reduces it, or allows it to grow depends upon the amount of technical debt. It is easy to see how a company delinquent in servicing their technical debt will have to increase the resource allocation to deal with it, reducing resources for product innovation and market responsiveness.
Put It All Together
The investor has made use of several specialists in an overall diligence effort and is digesting the information to zero in on the choice to invest and at what price. The business side looks good - revenue growth, product strategy, and marketing are solid. The legal side has some risks relating to returning a leased office space to its original condition, but the lease has 5 years to run. Now for technology;
• Tech refresh is overdue, so additional investment is needed or a move to the cloud accelerated - either choice puts pressure on thin margins.
• An expensive RDBMS is in use, but the technology team avoids stored procedures and keeps their SQL as vanilla as possible - moving to open source is doable.
• Technical debt service is constantly derailed by feature requests from sales and marketing. Additional resources, hired or contracted, will be needed and will raise the technology run rate. More margin pressure.
• Conclusion - the investment needed to address tech refresh and technical debt changes the investment value. The investor lowers the offer price.
Interested in learning more about technical due diligence? Here are some due diligence do’s and don’ts.
How AKF can help
AKF has conducted hundreds of technical due diligence studies over the last 10 years. One would want an attorney for a legal diligence effort and one would want a technologist for a technical due diligence. AKF does technology right. Read more about our technical due diligence offerings here.
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- Technical Due Diligence Best Practices
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