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The strategic imperative of software due diligence in technology investments
Software due diligence reviews a company's proprietary platform or SaaS products, crucial for investors to assess risks, growth, and scalability.
In today's rapidly evolving technology landscape, the importance of thorough due diligence cannot be overstated. In this article, we delve into the nuances of software due diligence, how it supplements traditional IT due diligence, and its strategic importance for investors in SaaS and technology-enabled companies.
What can go wrong
Failing to conduct thorough software due diligence can have costly consequences. Investors may unknowingly acquire platforms built on unstable or outdated technologies, suffer from poor code quality, or overlook critical security vulnerabilities. One such instance involved a private equity firm that invested in a logistics tech startup without inspecting its software architecture, underlying technologies, and codebase. Post-acquisition, they discovered severe scalability issues and security flaws that required millions in remediation costs, significantly delaying go-to-market plans and eroding projected returns.
Understanding software due diligence
Software due diligence is a complement, not alternative, to traditional IT due diligence, which focuses on the effective usage of commercial software applications, such as ERP and CRM. Software due diligence examines how a software or technology-enabled company has built its proprietary software platform or SaaS products. This shift in focus is crucial for investors looking to understand the technical foundation risks, growth opportunities, and scalability of technology investments.
The framework for software due diligence
Our comprehensive framework for conducting software due diligence consists of six key pillars:
- Investment thesis: Understanding the rationale behind software due diligence is crucial. It is important to determine growth and investment plans (e.g., platform acquisition, 10X growth, and product consolidation) to identify potential risks and opportunities, helping investors make informed decisions.
- Product and roadmap: This pillar evaluates the product’s features, functionality, and market differentiation. It assesses how the product compares to others in the market and identifies its unique selling points.
- Technology: This involves a deep dive into the software’s design, architecture, underlying technologies, and hosting environment. It examines the scalability of the software and the level of technical debt, providing insights into the investment required to enhance the software’s capabilities and cost-effectiveness.
- AI and ML capabilities: As artificial intelligence (AI) and machine learning (ML) become increasingly relevant, this pillar assesses the company’s foundation for AI and ML, including data infrastructure, talent, and business cases. It evaluates the company's readiness to leverage AI within its software platforms for growth and innovation.
- Organization and processes: This pillar examines the leadership team, organizational structure, and software development lifecycle processes. It assesses whether the company has the right leadership, people, and processes in place to support long-term growth, innovation, and efficiency.
- Cybersecurity: This involves evaluating the security practices integrated into the software development process and the hosting environment. It establishes that robust security measures are in place to protect the software, data, and its users.
Call to action
Technology sector investors and stakeholders should incorporate software due diligence into their evaluation processes to gain a deeper understanding of their potential investments, proactively identify risks, enhance decision-making, and ultimately maximize returns. CohnReznick’s expertise offers a robust framework for conducting thorough and effective software due diligence to position clients for long-term success.
Case studies
Situation 1: Negotiating a lower purchase price
- Issue: The private equity firm aimed to acquire software-as-a-service platforms from a HealthTech vendor but needed to assess their technical and financial viability.
- Action: CohnReznick conducted software due diligence and profitability analysis, uncovering that the software platforms under consideration relied on outdated technology and poorly structured code to generate unprofitable revenue.
- Impact: The firm negotiated a significantly lower purchase price, acquiring only select products at a favorable valuation.
Situation 2: Validating an investment thesis
- Issue: A portfolio company wanted to acquire a startup to upgrade its legacy software but needed to validate the investment thesis.
- Action: CohnReznick performed software due diligence, revealing the startup's platform lacked essential design paradigms for scalability and required substantial investment to develop capabilities to bring them at-par with the portfolio company’s legacy product.
- Impact: The portfolio company negotiated the acquisition at one-fifth of the original estimated price, demonstrating how software due diligence mitigates risk and protects ROI.
Final thought
In a technology-driven investment environment, software due diligence is no longer optional – it's essential. It equips investors with critical insights to uncover hidden risks, validate growth potential, and negotiate from a position of strength. By embedding this discipline into the investment process, stakeholders can align their capital with innovation, performance, and long-term value creation.
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This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.