The Process of Due-diligence When Evaluating A Technology Startup
Updated: Dec 13, 2021
Due-diligence is overall an audit of a company, digging into every important aspect to verify the claims, usually with reference to what is stated within the pitch deck. This boils down to an evaluation of the strategy, product and services, IT infrastructure, security, staff, development lifecycle and finances which make up the 6 primary domains of such a process.
A technical due-diligence process is better suited for tech companies, as it captures the areas that a traditional commercial due-diligence process would overlook such as a key person risk analysis or suitability analysis for legacy technology that may hinder the performance of the company. Tech companies can sometimes be extremely complicated so its best to fully understand what the company is all about. This all requires a specialist team of chartered surveyors, engineers and tech experts to properly appraise a company. The condition of an actual building and the equipment is important, but today’s more rigorous and commercial environment calls for technical due-diligence to become a key risk-management tool to help identify the liabilities and opportunities of an investment. This is typically done in the form of pre-acquisition survey.
The first step is a detailed introduction between the 2 parties with trust and openness being established which begins a dialog for later steps to come. From here you can calculate the company market cap by calculating the total market value of its outstanding shares. This will tell you a lot about the volatility of the stock and in the case of tech companies, it is likely to be high during the startup phase in the small cap space.
During this process, you do not make any presumptions regarding the stock itself but only collecting as much information as you can so you can analyze the tech stock later on. When you delve into the financial numbers, it is best to begin with revenue, profit, margin trends, financial statements and the balance sheet for the past few years so you can gather an understanding of the company’s financial state as well as where it’s heading.
It is well known that regardless of how good a company is, if the competition is better in every aspect then it will struggle. From this, you will need to size up the company against all the others in the market, typically this is done by comparing 2 or 3 competitors. It may be a good sign if the tech company has no competition as a conclusion can be drawn that it’s the first to come up with this new idea, however, it could also mean nobody has done the idea as there is a non-viable level of demand. Sometimes simply reading about a competitors can let you understand the primary company of interest and how they operate, it paints a clear picture of the potential and existing market.
The next step is the most math intense with valuation metrics. At first, using price/earnings to growth and PE ratio is a good start with a tech company, next you could move onto a DCF model with an appropriate discount rate, however, a tech startup may not have much financial history and will operate at a loss for many years so this method may not always be so suitable. Startup tech companies are usually “growth stocks” rather than “value stocks”, they have a high PE ratio as many investors speculate that the company will see rapid growth and therefore are willing to pay extra for the shares, having a long time horizon and holding onto the asset.
One very important step of the due-diligence process that is often overlooked is the company’s management and ownership structure with the age of the company being a substantial factor. If the board or owners are qualified and have a lot of experience in the industry, this can be quite a promising sign. If it is a younger tech company, you will usually find its founders are still around due to them believing they can make a dent in the industry. A lot of scam companies are uncovered because they have no professional experience in the tech industry and yet claim to have a ground breaking idea or technology. Institutional ownership percentages indicate how much the company has already been analyzed by institutions already, with a high personal ownership by the management team being a plus and the opposite being a negative.
The next step is quite important with startups as startups often may fail from simply running out of capital as they’re not profitable but instead running on loans and investor money. Seeing the company’s debts and assets will allow you to see if they are struggling or not and focusing on cash levels will let you know if they will be able to pay off short term liabilities. If ithe company is struggling, it could be an indication of impending bankruptcy. It must be stated that debt is generally not a bad thing, almost all companies have debt, however, it does depend on the business model of the tech company. Does it line up with their plans or have the finances spiraled off? To do further digging, reading the footnotes of financial statements and managers decisions would shed further light into their thought process and decision making across multiple years when presented with different situations.
You want to start discussing the inherent risks towards the end as it allows you to not get carried away with investing, you can understand both industry wide risks alongside specific ones for the tech sector as a whole. Is there any legal, environmental or social liabilities in the markets this company is operating into? Keeping a healthy amount of skepticism is always good as it drives you to dig deeper into aspects of the company you do not understand, leading to overall better due-diligence.
After all of this is done, successful technical due-diligence will often allow for an investment to be decided upon. To confirm all of these claims, documents will need to be placed into a shared data room or digital archive. This outcome is rare however as most businesses are simply not worth investing in for a multitude of reasons, finding an investor is often difficult and rare.