Technical Due Diligence For Startups: Preparation Checklist

If you’re a startup looking to strike a fundraising deal or close a merger or acquisition, you’ll eventually have to deal with technical due diligence. The process can be complex, long, and stressful, given what’s at stake. But in reality, it's not that tough if you take time to prepare well.

Do you want to be ready for IT due diligence? This article will cover the process's basics and the best strategies for ensuring a positive outcome. I’ve also included a handy checklist to help you prepare.

Let’s start at the beginning.

What is technical due diligence?

Technical due diligence (TDD) is a structured, in-depth valuation of your company’s technical infrastructure and architecture, software products, processes, and IT staff. This process includes assessing your products and services, hardware and software systems, ability to handle scale and growth, internal operations, management processes, employees, and security.

When is tech due diligence necessary?

You’ll have to undergo technical due diligence before M&A, venture capital financing, or fundraising rounds. The investor (acquirer or founder) uses TDD to analyze the technical state of your company and identify possible risks before finalizing the deal.

Who carries out tech due diligence?

Your potential investor will initiate IT due diligence and negotiate the scope and timeline of the process with your company. They can assess your company with an in-house team or alternatively use a third-party due diligence agency to do the heavy lifting.

Why is technical due diligence important?

Even an outstanding minimum viable product (MVP) won’t guarantee funding if there are problems with other aspects of your company.

Investors will go through myriads of documents, interviews, tests, and software due diligence checklists — all to determine the value, sustainability, and risks of your tech infrastructure. Fortunately, you can prepare for this assessment with your own strategy, internal audits, and employee training. Doing this helps you:

• Identify your strengths, weaknesses, and areas for improvement. Yes, a self-audit helps brace you for inquiries, but it can also improve your productivity and cost-efficiency.
• Organize your documentation to speed up the process and avoid legal problems. For example, you may discover unlicensed software applications, missing patent applications, or potential infringements on the intellectual property during an internal audit.
• Prepare your employees for interviews. The due diligence team may ask about your technical processes, development practices, and the logic behind certain decisions, so your team should be prepared to explain them.

Now that you know what technical due diligence involves, let’s see how it works in practice.

Stages of the technical due diligence process

Tech due diligence typically lasts from two to three weeks. However, poor organization, strategy, and communications can stretch the process to months or even break the deal.

This is where a roadmap can help. Here's the structure that can prove the most beneficial for both parties.

1. Preparation 

The due diligence process usually starts after both sides of the agreement (the investor and your company) sign a letter of intent (LOI). This document outlines how your companies proceed with the due diligence to reach the final agreement.

Both you and your potential investor(s) will also need to sign a non-disclosure agreement (NDA) to establish confidentiality. The same applies to agencies and third-party experts participating in the due diligence.

2. Kick-off

Both you and the potential investor will need to agree on all aspects of the due diligence process, including:

• The timeline for TDD and each of its stages
• The scope of the data, assets, and software for disclosure
• The number of key positions and employees to interview
• How you will provide your documentation and software

After laying out these terms, your company should prepare documentation for review. I recommend keeping copies of confidential files in a secure cloud repository and sharing access with the due diligence team.

3. Research

In this stage, the due diligence team studies documents regarding your products and services, software architecture, IP, human resources, internal operations, policies, and IT assets. They’ll also review your integrations, third-party solutions, security mechanisms, and development frameworks.

It's a good idea to make one or more people responsible for overseeing the process and providing any additional documents to the assessment team.

4. Meeting

Once the investigators have finished reviewing your documents, they'll usually want to see your technical side in action. This involves testing the performance and expected usage of your platforms through on-site or remote reviews. At this stage, the investigators usually interview your technical managers and key employees.

5. Follow-up

Your team should answer all questions from the due diligence team as they arise. However, the investor may return with follow-up questions after the initial assessment, so you should be ready to deal with them.

6. Report

The TDD team creates detailed reports of their findings. This documentation will cover the value of your IT systems, the condition of your assets, discovered flaws, expected updates, and potential risks.

Now that you’ve seen what the tech due diligence process looks like let's see what you can do to improve its outcome.

Technical due diligence for startups: key considerations

The focus of due diligence will be based on your startup’s investment stage. At seed funding, the investor will be more interested in the potential of your service or product. As you progress through Series A, B, and C, the scope and depth of technical due diligence increase.

That said, an investor can be quite thorough even if you're in the early stages. To help you, I’ve divided the process into different aspects of your company infrastructure.

Products and services

The investor will examine your software products and/or services. This process involves analyzing technical specifications, studies, and surveys, and even demonstrations and on-site tests. In addition to documentation, you may need to show market research and competitor analysis.

It’s best to refine your technology roadmap and long-term business plans beforehand. Your documents should be clear enough for anyone to understand the scope, level of detail, and budget estimations for future improvements and offerings.

IT systems and architecture

The due diligence team will want to look over your software and hardware systems. Their goal is to assess your IT based on its effectiveness, sustainability, and potential for integration with other services.

You should prepare documents and technical specifications for your:

• Hardware and software systems
• Architectural charts
• Cloud platforms 
• Data centers
• Web servers
• Product designs
• Application programming interfaces (APIs)

Your employees should be able to justify the logic behind your decisions regarding systems and architecture. For example, they could prepare statistics showing how using serverless platforms reduces your operational costs and maintenance in the long run.

Intellectual property

Intangible assets are major contributors to your company's value. Investors will research your patents, copyrights, and trademarks to make sure your products are well protected. They'll also want to ensure you won't infringe on rights, causing ownership or legal issues.

Management

Investors will research your employees and internal processes. This usually means studying your organizational chart with a list of full-time employees and contractors, departments, and associated costs.

Keep your chart regularly updated and reviewed. Consider setting up a database with all staff, their roles, privileges, and other important information. Ensure that critical updates (firing or access restrictions) are delivered to systems in real-time.

The interviewers can ask unexpected questions, so you need to prepare your staff in advance. At the very least, your CTO, CIO, project managers, and architects should be able to explain your company's values and internal policies as well as the rationale for their decisions.

Code and data quality

Code review and data health inspections are typical for due diligence software checklists. The investor can assess your:

• Programming languages, toolkits, and open-source components for development
• Code quality and coverage
• Software development methodologies and agile practices
• Server maintenance and support
• Unit testing for frontend and data repositories

If an M&A deal goes through, consider that your acquirer might restructure your organization or augment your in-house team. This means you have to make your code easy to pick up by other developers.

Cybersecurity

The TDD team will assess your security mechanisms, regulatory compliance, backend authentication processes, and authorization management. 

You'll need to ensure you adhere to data privacy standards and the latest practices in areas such as encryption, communication protocols, tokenization, multi-factor authentication, role-based access, and data monitoring. 

In addition, your employees should undergo routine training in security, social engineering prevention, and compliance. 

Tips to prepare for tech due diligence

Here are some ways to get ready for due diligence. 

• Keep key documentation up to date. Document all policies and procedures, organizational charts, and technical specifications for your platforms. Appoint people to keep track of changes and regularly review your documents.
• Use a virtual data room for document screening. A virtual data room (VDR) is a secure cloud repository that allows you to store, organize, and share key documents and communicate with the tech due diligence team.
• Implement a responsibility assignment chart (RACI). RACI is a management tool for dividing employees into specific roles: responsible, accountable, consulted, and informed. This tool encourages your teams to be more independent and showcases your advanced management framework.
• Provide supplementary material. A good presentation can contribute to your success. Don’t forget to create a few architecture and integration schemes, research graphics, sliders, or white papers.
• Audit your systems using the 4+1 view model. A 4+1 model describes your software architecture from four points of view (developers, system developers, project managers, and end-users) under different scenarios. Companies use this system to validate and illustrate their architectural design.
• Adopt DevSecOps. Cybersecurity isn’t something you can set up and forget. DevSecOps methodology places data security at the core of software development to make sure all your products are well-protected and compliant.
• Hire a team to assess your IT. Investors usually outsource due diligence to third-party companies, so why shouldn’t you? A professional software company can empower you with dedicated teams of engineers, architects, and project managers and help you refine your processes to brace for due diligence.

Something is always bound to slip through your fingers if you're new to due diligence. That's why I recommend that startups use a due diligence checklist with all key documents, questions, and points of interest. And I’ve prepared one just for you!

Technical due diligence checklist for startups 

I’ve collected the advice of corporate due diligence agencies and veteran CTOs like Mike Dunn to help you prepare for due diligence. The result is this structured checklist of things that can be covered during TDD.

Products and services

• Software products (deployed or in development)
• Architecture description
• Cost structure
• Customer analysis (current and potential customer segments, demographics, satisfaction rates, churn rates, lifetime value rates)
• Competitor analysis (market share values and positioning)
• Current and future offerings
• Possibility to test the MVP
• Complaints and warranty claims

IT assets

• Hardware systems (proprietary, purchased, customized, and leased hardware)
• Software systems (cloud platforms, backend applications, toolkits, proprietary and open-source software, and licenses)
• System condition (age, usage level, required of maintenance and support)
• Legacy components that require replacement
• List of APIs linking system components
• Ability to scale and integrate software modules
• Diagnostics and system quality monitoring tools
• Load testing methodologies
• Third-party agreements (contracts for data center, ASPs, and IT outsourcing services)
• Software system architectures (monolithic, microservices, or serverless)
• Budgets for servers, data centers, and operations (for last three years and current year)
• Technology roadmap (current plan, priorities, and future initiatives)

Intellectual property

• Patent and patent applications (domestic and foreign)
• Trademarks, trade names, and trademark applications 
• Registered and unregistered copyrights
• Licenses for third-party IT systems and software
• Limitations on patents, IT systems, and software licenses
• Collaboration agreements (licensing, collaboration, outsourcing, joint development, and research and development)
• Claims by or against your company (current, pending, and threatened)
• Approach to IP protection and enforcement
• Revenue and expenses regarding patents, trademarks, copyrights, and licenses

Human resources

• Organizational chart with departments and employees 
• Outsourced and contracted staff
• Roles and responsibilities of key members (including CTO and CIO)
• Roles and responsibilities of employees (support, development, testing, project management, and HR)
• Contracted costs for full-time and contracted staff (for last three years and current year)
• Employee awareness of internal guidelines
• Key performance indicators for the development team
• Software development lifecycle methodologies (waterfall, agile, scrum, and other iterative methodologies)
• Product development workflow and governance (project management, change management, business document requirements, and infrastructure management)

Security and compliance

• Security and controls framework
• Data encryption (3DES, RSA, Twofish)
• Authentication tools (multi-step authentication, adaptive authentication, one-password system, zero-trust identity)
• Role-based access control mechanisms
• Events logging and intrusion detection modules
• Data backup and disaster recovery mechanisms
• Penetration tests and cybersecurity audits
• History of data breaches, hacks, and other cybersecurity incidents
• Compliance with data protection regulations and standards (GDPR, PCI DSS, ISO/IEC 27001, HIPAA)
• Security and compliance training

This checklist isn’t exhaustive, but it should give you a good sense of what to expect during due diligence.

What’s next?

Technical due diligence requires detailed preparation. An experienced investor or due diligence agency knows the ins and outs of the process and will easily find inconsistencies in your IT operations, equipment defects, management bottlenecks, and potential risks. These can drive down your company’s value or even break a deal. 

A sound strategy can help you prepare for TDD and improve your chances of a positive review. The main things you can do are:

• Divide your IT due diligence into separate stages 
• Assist the assessment team with all their inquiries to avoid information gaps
• Follow our tips and checklist to prepare your documentation 
• Organize your documents in a secure virtual data room for easy review
• Prepare your managers and key employees for interviews
• Use management and assessment tools to improve your internal processes

Even with our tips under your belt, you shouldn’t shy away from consulting with professionals like Altigee to fine-tune your processes and development practices. Check out our other articles for help with typical startup challenges.