Due Diligence:
Assessing Technology Before the Acquisition

If you are buying a technology company, what you don’t know will almost certainly hurt you. You will care when your purchase fails to meet even your mildest expectations.

As part of the acquisition ritual, companies typically sign a letter of intent or an agreement of terms. Such agreements generally include a contingency clause that permits the buying company to perform due diligence.

In the simplest terms, an acquiring company conducts due diligence to examine the assets being purchased and ensure that what is expected is actually delivered. Technology due diligence focuses this examination on the technical assets associated with the acquisition.

Many companies treat an acquisition the same way they buy a car or a house. They make an emotional decision, then look for facts to support it. For example, you might fall in love with a sports car, then find ways to justify the cost and inconvenience of constantly having it in the shop for repairs. Too often, corporations "fall in love" with an acquisition and, from that point forward, reason, logic and prudence take a back seat.

Bad acquisitions can be painful, expensive, and even disastrous. To prevent a bad acquisition, you must be thorough, organized, careful and objective in all aspects of your evaluation.

In the technology business, it is a maxim that fewer than 50 percent of acquisitions succeed based on the financial and strategic terms used to justify the deal. Venture capital firms report that they consider themselves successful if even 30 percent of investment opportunities meet their goals. Those percentages can be made much higher through clarification of due diligence as it applies to technology.

What is Due Diligence?
Due diligence involves evaluating the legal, financial, marketing, sales, human resources and technology aspects of an acquisition. It means making sure that you are making the right decision at the right price and are getting the deal you expect. Successful acquisitions and investments in technology result from a well-executed due diligence process. Unfortunately, due diligence is not always treated like a business process. Two real-life examples help illustrate why due diligence is so important.

Getting to Market Quickly with Stolen Software
Company X acquired a software company, without completing thorough due diligence. Within days, another company, one of the largest software vendors in the world (and a major competitor) informed Company X, "Your new product contains our code, and we have obtained a court order to keep your new product off the market."

Company X took the product off the market, fired its developer, and hired an expensive developer to rewrite the software. It settled with the competitor for a large sum of money then sued the former developer. Nine months later, the company introduced its new product to the yawns of a disgruntled customer base. Company X lost millions of dollars on the deal, plus untold management time, and some measure of credibility and respectability with its customers.

Buying More Than Just a Pretty Package
Company Y needed a product to supplement its distributed product line. After two years of development, it had yet to produce the product needed. When they discovered Company Z’s product, it was love at first sight. The demonstration confirmed that this product was just what Company Y needed. They interviewed staff and customers and sent programmers in to look at code. They concluded a deal, and began marketing the product.

Soon after the deal was closed, reality struck as users began complaining about product problems. When the dust settled, the product turned out to be poorly designed and built. The problems were so significant that the product was pulled from the market for a year of redesign and reengineering. Company Y lost revenue, profits, considerable management time, market share, and credibility with its customers.

Six Lessons for Acquisition Success
Companies can learn important lessons from these examples to increase their rate of success. Here are six lessons for acquisition success:

1. Balance enthusiasm with objectivity. You’re considering a long-term partner, not a car. It is helpful to think in terms of "Should this investment be made?" rather than "How can this investment be made?" If executive management allows enthusiasm to overshadow reality, business expectations will not be met.

Insist on a top-notch interview process, and engage people with the skills to make it work. From a technology perspective, you need to interview the people who built the software and maintain it regularly. You need to understand what the software really is, what it does, and what it doesn’t do. Remember, software people sometimes talk in the present about software features that are in the future. Be careful.

One way to get the real answer is to ask good questions. Start with a solid list of questions, and do your homework before you interview. Understand everything you can about the software and the company behind it. There are great information sources like the Internet, annual reports, and articles about the company and its products. Use them.

Learn how to get good information from people without putting them on edge or on guard. Software developers are proud. With good interview skills, you will avoid asking questions that demean them or their software. Good interviewing involves an approach called triangulation. Ask the same question of at least three people at different levels in the company. Interview managers and technicians. You’ll find different perspectives that help define the reality of the situation.

And finally, be complete. Leave no stone unturned, no question unanswered, and no unsatisfactory answer unquestioned.

Rely heavily on customer feedback, but only if customers are actively using the product. Customers can be an important source of good information. However, you must exercise care when interviewing customers. Here are some guidelines:

Hand-pick customers from a complete customer list.

Visit customers who have deployed the product in a production environment.

Avoid new customers, unless you want to learn about the justification process.

Visit the customers onsite, in their own work environments, where you can interview two or more people. Watch their expressions when they talk about the product; actions often speak louder than words.

Visit customers alone – without the target company’s staff. You need customer feedback without influence from the target company.

Do your homework ahead of time. Look at problem lists, call logs, and incident reports; find out the seriousness of problems and how they were handled. Use this information to ask probing questions.

Staff your due diligence team with experienced experts, being careful that their expertise matches your needs. Good programmers make good code reviewers only if they’re trained in reviewing code. Technicians aren’t necessarily good investigators. Due diligence is an investigation, not a confirmation, so use people who know how to conduct an investigation.

Engage people who know the specific technology. Do not use a person who is qualified in a related but different field. For example, don’t use a mainframe programmer to evaluate client/server software.

Management of the due diligence process is critical to its success. Good managers define clear objectives and pave the way for a successful investigation. Without effective management, the investigative process can break down.

In one example, the code review process was entirely derailed by the target company. With only two days for a code review, the chief architect spent one and a half days explaining the product’s architecture (which proved to be more marketecture). Then the target’s chief architect watched over the reviewers’ shoulders while they examined the code. Effective management helps ensure that situations like this do not occur.

Be prepared to back away from or revise the deal. It is almost an unwritten law that once a letter of intent has been signed, the deal will be completed. That assumption can be fatal. Every letter of intent is based on the premise that due diligence is necessary. Companies won’t allow serious due diligence until the letter of intent is signed.

The acquiring company has precious little detailed knowledge of the target company, its people and products, until they enter the due diligence period. Your due diligence team needs to understand that they may find warts during the evaluation and that you are not afraid to walk away from the deal if these are serious.

Alternatively, you may decide to change strategies. You might decide that you will acquire a single product or enter into a marketing relationship, rather than acquiring the entire company.

Spend adequate time and money to complete an effective analysis. Why? Because an acquisition mistake is one you live with for a long time. It depletes financial, management and staff resources. A serious mistake on one acquisition makes it much more difficult to justify the next one to the Board and stockholders. Well-meaning companies often engage overworked, under-qualified staff for due diligence, and provide the team with little guidance. This is a recipe for failure.

While there is no "right" approach to take or dollar amount to spend, it is clear from the litany of industry "legends" and failure rates that typical due diligence resource allocation is inadequate. Conducting an effective due diligence effort is like an insurance policy against failure. Those who have failed are the first to recognize the value of such insurance.

Boost Your Acquisition Success Rate

Few companies have acquisition success rates over 50 percent. Those that succeed do so because they have a business process to evaluate the technology, and they follow it unfailingly. If acquisitions are in your future, learn from the few, and boost your own acquisition success rate.