With technology becoming a standard part of today’s transaction process, both financial and strategic buyers come to the negotiation table armed with insight about potential technology gaps and issues – insight they are using to negotiate discounts during the process.
Proactive sellers can counter this with diligence of their own. “Sell-side” technology diligence can shed light on particular areas of weakness and help a seller identify ways to mitigate those risks and their potential impact on deal value.
The earlier it occurs in the deal-preparation process, the greater the opportunities to preserve – or even enhance – transaction value. This article examines key short- and longer- term opportunities for using the insight gained through sell-side technology diligence, as well as additional implications when preparing a software company for sale.
A decade ago, few buyers conducted formal technology diligence. Those that did usually relied on a limited, “check-the-box” exercise provided as an add-on service by a diligence partner that didn’t necessarily specialize in technology. In other words, such diligence didn’t produce much evidence to drive valuation discounts – and sellers experienced few “hits” to valuation at the time of sale based on factors related to the technology environment.
As technology has become more central to performance and competitive advantage, that approach isn’t effective. Today’s buyers spend time and money on formal technology diligence, the primary exception being smaller, add-on acquisitions where the value is in the customer base or product(s) being acquired or geographic expansion. As a result, many sellers today are feeling the pain of value erosion or discounts based on technology gaps or risks identified during diligence. Those include applications that are not supported or not scalable, outdated infrastructure, lack of security, compliance gaps, or insufficient disaster recovery capabilities.
Sellers have learned some lessons from an increased focus on technology diligence, and are getting smarter. Now, sellers are performing their own technology diligence to avoid a valuation hit down the road. This “sell-side” technology diligence can contribute both qualitative and quantitative value during the deal negotiation by surfacing issues and enabling the seller either to fix the issues prior to sale or, at the very least, to disclose them honestly to prospective buyers.
Think of it as preparing to sell a house. If the seller lists a house at $400,000 and is upfront with potential buyers about the leaky roof, the buyer may assume the seller has baked the expenditure of fixing the leak into the price. But if the house is listed at $400,000 and the buyer discovers the leak during the inspection, that buyer will likely ask for and receive a discount to fix the roof after close.
Addressing core technology issues can be time consuming. Therefore, the earlier a potential seller becomes aware of critical issues, the more opportunity the seller has to mitigate their impact on future deal value. West Monroe’s 2017 research with Mergermarket suggests that private equity investors begin sell-side deal preparations early in the holding period (see “Sell-side preparation starts early” on pg. 4) and that strategic sellers are also likely to be thinking ahead about maximizing deal value.
Whether your deal is imminent or a couple of years fown the road, sell-side technology diligence can help you avoid value erosion.
An imminent sale – less than three months – doesn’t allow much time to act on the findings of a sell-side technology diligence. Nevertheless, there are several ways you can use such insight to reduce the potential for value reduction.
It helps avoid the mad scramble of trying to satisfy incoming requests during the heat of deal negotiations.
If done well and thoroughly, it will make the diligence process more efficient.
It provides a good first impression for potential buyers. Have you ever walked into an open house and found a messy home? If the seller hasn’t done the “little things,” then you wonder whether it has adequately handled the big risks.
If you are a couple of years away from selling, then you have a considerably longer runway for making changes – mitigating risks, removing scalability barriers, or taking out costs – that not only uphold deal value by avoiding discounts but also potentially increase enterprise value.
While every business, technology environment, and deal is different, there are certain opportunities to identify and address issues that buyers will scrutinize during their diligence.
Deals for software companies or assets have become very popular as organizations across an array of industries look to leverage technology as a differentiator. In fact, 2016 was a blockbuster year for software mergers and acquisitions, with the highest number of such transactions – just over 1,400 – since Mergermarket began keeping such records 1999 (see below). Total deal value was close to 2015’s record high. Both private equity and strategic buyers are very active in this market, and the 2017 West Monroe survey with Mergermarket indicates that buying momentum will continue.
If you are planning to sell a technology company or assets, the steps you take to prepare for the sale will be even more critical – because the technology represents the value for the buyer. While all the points already outlined apply to technology sales, there are several additional areas that potential buyers will scrutinize.
Reduce the number of technical platforms supported. If you have three or four different technical platforms supporting four or five products, then you are taxing the organization’s resources. Multiple technical platforms require a larger R&D team and higher maintenance costs. If you can consolidate, you should.
Decrease the size of your version footprint. If you still provide on-premises software, you are probably supporting multiple client versions. This drives higher operational costs, so you will want a documented plan to reduce your version footprint. This can be challenging because it also requires convincing your clients to upgrade. At the same time, if you don’t already have a software-as-a-service (SaaS) migration plan, begin putting one in place. With the exception of a few niche industries, on- premises software will be very limited five years from now.
Solidify your software development process. Your software development is your assembly line – but unlike a traditional product assembly line, it is more difficult to fix due to factors such as geographic dispersion of the process and team. Issues in the software development lifecycle (SDLC) lead to higher R&D costs and bad product releases and can hinder customer satisfaction. Many developers underestimate the work involved to address and fix SDLC issues. Depending on size, geographic separation, and number of platform technologies, improving the software development process can certainly take six to 18 months.
Reduce technical debt. Technical debt accrues when developers take shortcuts to fix a problem. Too much technical debt causes developers to spend excess time on maintenance and not enough on new development. Some technical debt is okay, but over time it can growth to levels as high as 30% to 40% of development time, for products that are not built or maintained well. You will need to quantify the estimated amount of technical debt in your environment and its corresponding drag on development. From this, you can define and pursue steps for addressing technical debt in advance of a deal – when you can expect sophisticated buyers to really scrutinize this area.
Strengthen product management. Your product management function is like an orchestra conductor. Without a well-run product management function, all other key functions operate less efficiently. One area to focus on: Make sure the product management function has or is creating a product road map with market, functional, and technical inputs.
Timely sell-side technology diligence provides insight for shoring up weaknesses that could erode value at the time of a deal. As with many things, the earlier you start, the greater to potentially affect deal value – and the greater your opportunity to benefit in the interim.
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