Modernizing technology due diligence

At a glance:  

• Global M&A activity declined for the fourth consecutive quarter, falling 32.2% in deal value from the peak in Q4 2021.
• Downward pressure on multiples, means that value creation is becoming increasingly important to the investment thesis, and with decreasing deal volume, firms are finding fewer opportunities to identify winners. 
• Traditional methods of validating the technology and digital strategy using “top-down” industry data and assumed top-line growth often miss important insights specific to the Target.
• An updated approach that uses modern digital accelerators results in a more informed view of value creation opportunities and technology risks.

Global M&A activity continued to decline for the fourth consecutive quarter, falling 32.2% in deal value from the peak seen in Q4 2021.  Sharp increases to the cost of debt have restricted lender access. Particularly, outside of the largest and most established funds, adding increased liquidity risk, especially if earnings fail.  These factors increase the stakes for deals in 2023, underscoring the need for firms to spend additional energy evaluating perspective Targets. 

Global M&A activity by quarter

Sharp increases in the cost of debt to fund buyouts have driven interest coverage ratios lower, increasing liquidity risk, especially if earnings fail.

The impact of technology on the success or failure of business deals is more significant now than ever before. With the rapid advancements in technology and the proliferation of digital disruption, virtually every industry is undergoing transformation. However, many investment firms continue to overlook the potential ways that technology can enable growth and add value.

Inspire11 sees technology as a crucial component of the overall Diligence process, identifying risks but also using access to systems and data sources to reveal Value Creation Opportunities (“VCOs”) outside of the traditional realm of technology.

When evaluating the upside potential of a Target, traditional methods using benchmarked, “top-down” industry data often miss important insights specific to the Target. An updated approach using modern digital accelerators results in a more realistic, informed view of VCOs while establishing plans that operation teams are better positioned to execute. Thanks to evolving trends in data and analytics, your Technology Diligence provider should be well-skilled in rapidly identifying meaningful insights that inform the deal as much or more than top-down industry benchmarks. For example, we identified a potential 20% EBITDA lift for a large logistics company by using our frameworks and tools to identify pricing and retention insights.

For software deals (or Targets with a large software footprint) in particular, firms must also understand the technological competitive moat: which aspects of the software are easy vs. difficult to replicate.  In a deal for a prospective marketing technology startup, we assessed the viability of the target’s technology roadmap and clearly explained the ability to scale the business model to different markets.  Demystifying the target’s technology secret sauce and roadmap allowed our client to negotiate the multiplier more confidently.  Correctly assessing a deal’s upside and risk depends on separating the sales pitch from a clear understanding of the current state software and the effort and feasibility of realizing future state vision. The best diligence providers will effectively translate the technology to business processes and demystify technology concepts into plain language where applicable to facilitate better decision-making.

The impact of technology on business value

As companies increasingly rely on technology to power its business, we continue to see examples of failed major technology initiatives, cyber incidents, and failed add-on integrations negatively impacting business, often resulting from gaps in people, process, or technology. More specifically, we’re finding that:

• Material cyber security risks in 50% of our technology diligences.
• “The possibility for unsuccessful [add-on] integration is high” and “[an add-on] strategy can easily backfire for unprepared buyers”

Diligence providers must effectively separate material findings from “nice-to-have” recommendations and be able to accurately estimate required investment and time to remediate material findings. Our alignment to the investment thesis results in a clear perspective on required vs. strategic recommendations, and our delivery experiences enable us to provide accurate recommendation estimates.

Our approach

In the coming years, the Technology and Commercial workstreams will increasingly become intertwined. Seek a diligence provider that brings integrated teams, with strategists that embrace technology and technologists that embrace the strategy. Firms that embrace this approach more accurately validate investment hypothesis to inform purchase price, and create more actionable plans for quick execution post-close.  With fewer at-bats for both buys and sells, increasing the hit-rate of successful hold periods will best position firms for success in 2023.   

At Inspire11, we feel so strongly about our ability to identify value during technology assessments that we are willing to align our incentives with our clients.  Diligence partners that are willing to engage outside of a traditional fee structure provide firms with another level to control deal risk.