16 February 2019

Technical Due Diligence, Part I

Would you invest in a race horse without ever seeing it gallop? We apply the same reasoning to high-tech investments as we explore the process and value of technical due diligence.

2018 was a record breaking year for venture capital investments, with tens of thousands of investments worth upwards of 300BN dollars.
A significant portion of these investments went into companies developing breakthrough technologies in emerging markets, with strong potential for disruption and growth.
Alas, therein lies the challenge - how does one manage the investment risk for a company who is taking on a challenge few others have, or tackling a problem that did not exist a few years back?

Investors are usually very adept at the corporate and executive team risk management process, commonly known as due diligence.
Classic due diligence usually follows a term sheet, and in this period of time, analysts, lawyers and accountants are verifying facts and figures, while trying to identify potential risks for the investor.

However, in my personal experience, and also as has been exemplified in the theranos scandal, investors simply do not invest enough in technical due diligence. To use an analogy, it is like checking a race horse’s pedigree, teeth and hooves, but never testing its ability to actually run extremely fast.
The main goal of a technical due diligence then, is to manage the risk revolving around the company’s technological achievements and potential, correlating expectations to the maturity level of the assessed company and its growth projections.
The more the company is reliant on its technological edge for success, the higher the importance of the technical due diligence becomes

Given that there are no generally accepted standards and frameworks for technical due diligence, we have built our own over time. In this series of posts we will describe the framework and process we use and the deliverables we create along the way.
It is by no means perfect or fit for every situation, but we do believe that it serves as a good basis for adaptation and includes some universal concepts that should carry over to many different fields and situations.

Assessment Team

First and foremost, for an effective TDD you have to make sure that the person leading the assessment is a the right fit for the company and technology at hand. The TDD requires the assessor to be able to see beyond the hype, ask the hard questions, and evaluate the answers provided by the assessed company.
Significant money is involved and founders will go through great lengths to make themselves and their companies shine through the process. The assessor has to have both the technical as well as the mental capabilities to provide a counter force to eventually draw a balanced picture of the risks involved.
For example, we consider ourselves a good fit to assess cyber security companies and products, since we have been involved in the field at both the technical and executive level for many years, on both sides. However, we would not be a good fit to assess a new biotech startup, as we can be easily overwhelmed by terms and technicalities we are not familiar with.

Framework

Our TDD framework consists of four pillars:

  • Leadership
  • Talent
  • Solution
  • Process

First, we want to make sure that the technological leadership has both a clear vision and the ability to draw and retain talent. Much like an expedition venturing out to uncharted territories, you need a captain, and she better know where she’s headed, have confidence in the journey, and have the reputation and connections to get great shipmates on board.
This is true generally to the leadership of the company, and the technological leadership is no different.

Second, we examine if the existing talent has the required qualities for the journey and challenges ahead, and what insights they may have about the status of the ship. Their insights are usually highly valuable in getting a more balanced picture of the gaps between the vision and the reality, and gaining those insights requires soft skills and trust building.

Next, we look at the compatibility of the solution to the problem the company is trying to solve, with a special emphasis on future compatibility. That is, what adaptations and costs would be required to account for rapid growth, fierce competition, and changes in the technological environment.
If you will, we are making sure that the ship is built to withstand the hardships of the journey, and can be adapted for expected, and less expected challenges.

Finally, we look at the process including tools, standards, procedures and everything else that binds the three previous pillars, turning them into an effective and efficient machine for the company.

In the next posts we will dive into each of the pillars and get our hands dirty with some examples.

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