Top 9 Reasons to Conduct IT Due Diligence

In too many M&A transactions, even those related to software and technology companies, IT due diligence is, at best, an afterthought. I’ve even been involved in deals valued in the high eight figures where IT due diligence accounted for, maybe, 1-2% of the overall due diligence effort.

There is no doubt that financial and legal due diligence are critical, but IT concerns too often receive insufficient consideration. While IT due diligence rarely uncovers information that kills a deal, it has the potential to save the acquiring company thousands of dollars during the transaction.

This article will explore the top nine reasons to conduct IT due diligence when acquiring a company.

1) Be Sure the Technology is Real

A financial or legal expert simply can’t tell if a target company’s product is real. You can’t rely on a PowerPoint presentation or even a product demo to confirm authenticity — it’s too easy to create something that looks great but doesn’t do what it’s expected to do. Ideally you should have an expert in the target company’s specific technology and industry review source code, product plans, etc. At a bare minimum, you need to have a technical person sit in on a demo and ask questions.  If a technology expert from the acquiring company or investor isn’t available, consultants can be hired for this purpose.

2) Determine the Technology’s Compatibility

Even if the technology is real, you need to know if it’s compatible with the acquiring company’s technology. If the target company uses leading edge or proprietary technology, it may not integrate easily, if at all, with the acquiring company’s legacy systems. This can have serious ramifications for the integration of the companies, the maintainability of the software and the retention of key employees at the target company.

Even in an acquisition where the target’s main product or services isn’t completely focused on technology, it’s valuable to understand the platforms used for business services such as email and CRM.  After the deal closes, integrating or migrating these services may require significant resources, and it’s best to understand what will be required as soon as possible.

3) Verify that the Technology can be Supported

This broad area includes basic things, such as whether or not the target company has a clean copy of the source code for their technology, or whether they own the rights in the first place. These issues come up more often than you might think. Even if there is a viable copy of software source code and all ownership rights are in order, are the people who wrote the software still employed by the target company? Don’t expect any of this information to be volunteered – you have to look for it and you can’t make any assumptions.

4) Uncover Licensing Risks

It’s not uncommon to find that a startup or small technology company has not properly licensed all of its production or development software. It’s not always intentional – in the frenzy of getting a product developed and into the market, any number of administrative tasks can fall by the wayside. Whatever the reason, at some point the fact that additional licensing costs are due will come to light. You want it to be before the transaction closes, not after closing or the expiration of any holdback period for reps and warranties.

5) Establish the Technology’s Scalability

If you determine that the target company is real and is generally compatible with the acquiring company’s technology, it is important to also consider the scalability of the technology. How will the software or systems behave if the number of customers doubles, or increases tenfold? Will the technology expand gracefully with a low marginal cost, or will significant growth require a large investment in new servers or other hardware? In the worst-case scenario, a complete re-architecture of the technology may be required. Even if this doesn’t kill the deal, it represents a significant cost that needs to be uncovered and included in the terms of the transaction.

6) Identify the Key Employees Associated with the Technology

IT due diligence includes interviews with some or all of the target company’s technology staff. Through these interviews, you can get a good feel for the personalities involved. Will they work well in a larger organization, if that describes the acquiring company? If these are important employees, you may need to put employment agreements or retention bonuses in place to be sure the key players remain post-transaction. Incorporating these plans into the initial agreement can ensure that the necessary employees are motivated to stay and keep the technology sustained.

7) Determine the Appropriateness of Current Levels of Resources

Many smaller companies scrape by with minimal resources when it comes to things like networking and other IT infrastructure. Has the target company put off making needed investments in order to artificially inflate profitability? If the systems are noticeably outdated, you could be walking into a large front-end investment that should be included in the sale price. Are you confident that your legal or financial experts would notice?

8) Identify Opportunities for Cost Savings

By the same token, technical knowledge is needed when it comes to determining a realistic level of synergies in the transaction. Don’t assume that simply because both the acquiring and target companies have data centers, you’ll be able to combine them after the deal occurs. Are you sure the technical platforms are compatible? Can you evaluate the skill sets of the target company’s IT staff to determine if there is any overlap with the acquiring company’s staff? Confirming the synergies can help avoid sunk costs and maximize the benefits from the transaction.

9) Discover Hidden Gems

It’s not unheard of for the technology staff at a company to be working on projects that the senior management of the company isn’t aware of. These experimental projects aren’t likely to end up in the target company’s CEO’s PowerPoint of company products. The right technical expert can make the connections between these “secret projects” and the strategy and technology of the acquiring company. These projects are often uncovered during the employee interviews of IT diligence.

These are just some of the most important reasons to conduct an effective IT due diligence effort. Having a technology expert on the due diligence team is the best solution, but when that’s not possible, the IT Due Diligence Guide can go a long way towards increasing your appreciation of the IT concerns involved in your transaction.

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