Technical diligence starts when a startup or company has been approved for outside capital, but needs to be inspected to insure the value of the technology is "good enough" to accept investment. The average startup has something like 1/100 odds of receiving funding once they pitch a VC firm, which is why if investment is offered the ball shouldn't be dropped during technical diligence. Most issues in technical diligence can be prevented. Since technical diligence is part of the investigation process to receiving venture capital, any business in theory could proactively prepare for technical diligence. Here are some business-specific reasons to understand with technical diligence.
Stage of the Company
To understand how other companies are getting their valuations, you must understand the stage of your company and what your user growth and financials look like compared to other companies at this exact business stage. Don't just compare revenue to revenue or headcount to headcount. Understand what kind of super growth companies in your space are achieving.
The biggest indicator I have seen is if companies have a realistic understanding of if they are in a scaling mode or product building mode. Those stages have wildly different budgets, so they cannot be measured the same.
Intellectual Property Awareness and Protection
Are there NDAs on file? Clauses around IP and ownership? Completed patents and trademarks aren't critical, perhaps just pending, but starting out with the right contracts is important. There often isn't "secret sauce" that is worth creating a patent overnight. Most patents take years of work and documentation. Access to tech-savvy IP professionals who can handle things that can go "viral" quickly with users is crucial. Often the more users a program has, the higher the stakes become, placing importance on who owns the IP.
One of the worst lawsuits I ever witnessed involved a startup that hadn't protected any of its IP. The startup pulled the plug on their code developer without paying their final bill, lost their code, and had no legal rights to it.
Investors want to see massive growth, which requires solid infrastructure. Technical diligence often covers version controls (Github), monitoring, load testing, unit tests, code reviews and automated scaling. Without the right tools, the tech can't scale. If you have zero plan for scaling or an unrealistic one, investors can tell.
There are multiple ways to review security: there's intrusion detection and prevention, backups and recovering systems, and security certificates like SSL or TLS to add layers to the product or website. Depending on the product, this part of diligence mostly covers legal bases for VC firms. If there isn't security in place for tech, this shows lack of leadership which permits the pull of any capital.
I consulted a company that fired a CTO who had control of everything including the main servers. We had to delicately regain server access without alarming him or others. Everyone did okay, but I questioned how the startup ended up in that situation.
Documentation is tricky because it can sometimes be unproductive. It is, however, necessary for others to understand how things are built and where to find important tools. Technical documentation is not expected to be perfect, but initial wiki's or Github repositories for logins are expected.
Investors want to see that leadership has considered things from every level. Documenting everything without holding back the business is crucial and helps share knowledge. Often documentation is the true key to scaling.
The challenge for companies is finding the right investor. For investors, finding the right company to invest in can be a journey. Raising capital shouldn't be hard. Set your mindset on having quality technical diligence. In post two, I will talk more about specific technical diligence preparations like risk management and development budgets. Once you understand the business stage of growth, planning around technical diligence becomes an easier process.
About the Author
Ellie Cachette is General Partner at CCM Capital Management, a fund-of-funds specializing in venture capital investments. CCM invests into venture capital firms who then invest into startups. For more information on Ellie or her firm visit www.cachettecapital.com.