10 Reasons Why Tech Deals Blow Up in Due Diligence
The most frustrating experience for a management team, the board and the investors is to be in the exclusivity period preceding an acquisition and for one reason or another the deal blows up and the buyer walks away.
What is generally more frustrating, is the realization that most of the situations that cause this type of impasse were controllable had the management team been more careful in advance of the diligence process. I was the founder of a boutique investment bank in Palo Alto that completed over 250 sell-side transactions in my time at the company.
In my blog today, I will review with you the ten areas that are important to address in advance of a formal due diligence process and the steps that should be taken to avoid an early termination of a potential acquisition.
1) Audited Financial Statements Aren’t Ready
Most investors make a bad decision and delay the cost of an audit to save money. The rationale is reasonable but the impact is usually negative. I demanded that every client be audited before I would engage. I wanted to make sure the numbers stood up to the test of an audit and there was no aggressive accounting treatment to accelerate revenue and profits. Most buyers will also require an audit before closing so in my mind it is better to take care of this early.
2) Unprepared Code Scans
In the world of open source, buyers are very concerned about buying “tainted” code. In almost every case they will run an external code scan using Black Duck or Palamida. The reports that are produced by these third parties can be not only intimidating but actually devastating. This is an easy issue to get in front of. I encourage every company at least six months before any strategic initiatives to do their own scan with one of these external parties so that if there are problems they can be remediated.
3) Unclear IP Assignments from all Developers
To be very clear, when a buyer pays a lot of money for a software company it wants to ensure with 100% certainty that the code is owned outright and that EVERY developer who has ever worked on the code base (whether employee or contractor) has assigned IP rights to the company. Do not give a loaded gun to a developer who has not assigned IP as you will not be happy what it will cost to get this assignment later.
4) Lack of a Quality CFO
Again for cost saving purposes this is often a capacity that is ignored until too late. It impacts every part of the financial reporting system. Buyers want timely accurate financials. They want to understand performance to historical budgets. They want detailed 5 year plans and thoughtful models, none of which can be done quickly. They will want revenue bridges to next year’s forecast. They want detailed pipeline analysis and historical outcomes by bucket.
Early on, this can be remedied by a rental CFO who only works part-time and luckily there are some great ones working this way. However, as the company progresses you need a full-time senior CFO. In the past, at deal close the CFO was generally among the first to be terminated. Today, that is no longer the case. Most of the time the buyer will want the CFO to stick around through a transition period.
5) Messy Employee Agreements
Make sure your HR files are fully updated. Make sure that every employee has a file, and that all have signed the company’s employment agreements. For top executives bear in mind that buyers do not like full acceleration on change of control for option holders. They want the management to be highly incentivized post-close so that a conflict will not exist. My suggestion is to adopt a two step acceleration plan that requires both a change of control as well as either or both of a change of work address or change of responsibilities.
6) Inflated Forecasts
The natural reaction for a CEO when asked by a potential strategic partner to provide a forecast is to inflate the numbers. This is actually the curse of death as the process will always take longer than you think and the team will need to make these inflated numbers. Failure to do so will actually reduce purchase price or more likely cause the potential buyer to lose confidence in the team. Remember that valuation for the buyer is really based on what they can do with the business post-close. Always “under commit and over perform.”
7) Messy Customer Contracts and Weak Reference Calls
Make sure that your contracts automatically roll over in a change of control. Do not allow your customers to insert change of control approval clauses as you will regret this later. Fight this early and don’t give in. The consequences of this insertion is you give them the right to renegotiate. In addition, remember that late in the diligence process a large number of your customers will be called. This can be controlled to some degree but it will not be avoided. This fact alone reinforces just how important it is to maintain strong relationships with your customer base. Excellent service levels and NPS scores require effort but it will pay off later. But by the same token, make sure that contractual agreements executed by your company (for example, reseller agreements) can be canceled at your option or post-closing by the buyer.
8) ROFR Bomb
Many times I was involved with companies that had strategic buyers in the cap table. I am generally not a fan because often it goes along with a right of first refusal clause (ROFR). If you are going down this path do not allow this to occur. It is very toxic. Many buyers will not consider an acquisition of a company with a ROFR. A softer and more amenable alternative (which should satisfy the strategic investor) is a right to notification. This will not scare off other buyers and in fact can be very helpful in creating a competitive bidding process which results in higher outcomes.
9) Leading CTO, Technical Processes and Documentation
Similar to the CFO, the CTO is a crucial element of the diligence process. Are you using state of the art technology and processes? Are all of the processes well documented. Is the CTO a visionary leader that attracts the best team members and builds loyalty? Can they go head to head with a third party concerning the choices they made in the development process? If you have any doubts, you know what you need to do. This person will either build confidence with the buyer or reduce credibility to zero.
10) Management Alignment
I saw too many deals where the investors got greedy and did not properly arrange the financial incentives for the management team. It is impossible to get a deal done without key management’s cooperation. Ensure in advance that you have created strong alignment. If a carve out is needed, then act decisively and proactively with the team as 10% of a number is better than 15% of nothing.
This is not an attempt to provide an exhaustive list but rather using my own experiences to help companies and their investors consider important areas than can be easily addressed in advance that will improve the certainty of closing!
