Category: Due Diligence

  • What is technical due diligence for Venture Capital?

    I’m Technology Partner in a VC firm, Oak HC/FT. I help look at companies we’re considering investing in, and I help out as needed after investment. Recently I’ve been thinking about what I do, mostly because I’ve encountered multiple cases of technology due diligence performed on companies I know well. To put it plainly, I don’t do it the same way.

    The firms whose work I’ve seen are professional, well-regarded groups. Their work fits into a pattern of similar work I’ve seen over many years. Their work can have value.

    My Evolution in Tech Due Diligence

    When I started performing tech due diligence for the VC firm Oak Investment Partners in 1992, I had no specific idea of how to do it. My background had been almost exclusively on the “other side,” i.e., working and building software, mostly for small, entrepreneurial companies. But I’d had occasion to dive into bodies of software over the years and figure them out, so I guessed I’d be able to figure it out better than any non-programmer could. All I can say is, I went through quite an evolution from there.

    The starting point was clear and simple: evaluate the software. There’s a lot of work involved and not many people have the skills to do it well, but there’s no magic. I quickly developed an outline for what an evaluation consists of. It was a few pages long. Here’s the last part:

    1

    The earlier parts … well, let’s just say it was comprehensive.

    I marched forward doing the work and interacting with the people in the company being evaluated and with the partners in the VC firm. I evolved my views of tech due diligence.

    In the late 1990’s, I did an on-site tech diligence of a little company called Inktomi. It was started by a couple guys from U Cal Berkeley, one a young professor and the other a grad student. They were hard at work on a project called NOW – the network of workstations, which was an early attempt to build software that would enable a bunch of workstations connected by fast networking to solve really big computing problems, of the kind normally only so-called super-computers could handle. They built the software, and needed a big, big problem to solve to demonstrate that it worked. There were already full-text databases around that ran on standard computers. Also at the time, the internet was exploding, with no end in sight. There was an emerging need to help people find things on the internet. At the time, the best available solutions were “portals,” of which Yahoo was a leading example. A portal was a densely populated page managed by people who would put up links to the main things people were interested in. But what if you wanted more? Wouldn’t it be great to have a full-text search engine that could index and search the entire internet, even as it grew endlessly?

    This is the problem Inktomi took on. No existing search engine could come within a factor of 100 of indexing and searching the whole internet at the time. The boys at Inktomi used their NOW infrastructure to attack the problem, first building a crawling and index-building system, then building the search. It wasn’t easy, but it turns out that it fit right into the NOW approach. If you understood it, you could see that by adding workstations to the NOW, you could scale the index endlessly, no matter how large the internet grew.

    I walked into the second-floor warren of offices above stores on Shattuck Ave. in Berkeley, with machines and people crammed in anywhere they would fit. I already had heard the basic idea. I looked over people’s shoulders at screens, and noticed some things about the C code there. I asked questions and discovered they had implemented parallelism not by using standard UNIX multi-tasking, but by a super-low-overhead coding method. I saw the cables and boards, and found out the clever things they had done to minimize inter-workstation latency. And some more stuff.

    Before long, and without doing anything like the exhaustive inventory of my original approach to due diligence, I had discovered the originality of their approach and their impressive implementation of it, which would give them a lead over any competitors that would emerge. I became a strong advocate of the deal.They took our money, the largest investment we had made in a company to that date, and ended up making over 100X return.

    Of course today, we don’t “inktomi” for things on the internet, we “google.” That’s a story for another time, and happened after Inktomi had attained a public market valuation in excess of $10 Billion.

    I tell the story to illustrate one of the fulcrum points of my evolution in performing tech due diligence. The way I did it and the resulting win helped spur me on to doing what the VC really needs, which is to leverage my experience and skills into getting insights into a potential deal that are invisible to the other members of the firm because of their lack of detailed knowledge of software and systems. The insights can range from “makes no difference here” to “OMG negative” to “how could I have known that super-positive.”

    What I finally evolved to, and continue to work at, revolves around this simple fact: the VC firm wants to know if this technology, the way it is today and is likely to grow into the future, will make the company into a success and end up making money for us and our investors. That’s it! Everything else is a footnote or appendix.

    The vast majority of tech due diligence I see performed by firms who specialize in performing that work, and who are regularly retained by groups doing investments and/or acquisitions, is not about this. What I almost universally see is something like what I started with long ago, with this very important added element: how do the tech, the people, the organization, the process, the deployment and the architectural choices made by the firm compare to widely held industry standards, best practices and regulations? When I look back at my old outline, I see this element entirely missing! Thinking back, I realize that the reason is that I had already decided that those widely held standards, unlike the ones in law and accounting, were a pile of crap. I had already noticed what I later began to systematically study and write about, the difference between the "war time" software practices of winning startups, compared to the widely accepted "peace time" methods.

    Conclusion

    If you want to acquire a tech-oriented company, you naturally want to perform due diligence. If you’re a big company, you may want to acquire it for its momentum and market edge; Facebook and Google do lots of acquiring for this reason, among others. You want to know how well the target company conforms to the kinds of standards, practices and procedures that your internal organization is held to. But if you’re a smart VC, you want different things from tech diligence. Does the tech give the company an “unfair advantage?” Do they approach tech with a speed-oriented, get-stuff-done attitude? The tech may be 2X better than the incumbents, but could a newcomer pretty easily get 5X? Sounds improbable, but this kind of thing happens all the time. If you’re a VC about to place a bet on an up-and-coming company, that’s the kind of tech input you should want.

  • Due Diligence: Financial, Legal and Software

    When you are going to acquire or make a major investment in a company, it makes sense to perform due diligence. Not only does it make sense, it's a fiduciary responsibility! Due diligence on the company's financials are a no-brainer. Same thing with legal. Wouldn't want to be surprised by a landmine in one of the contracts, would you? If there is software involved, most people perform technical due diligence. In each case, you hire an expert who combs through the relevant portion of the company. The expert produces a report, at minimum highlighting any deficiencies.

    They're all pretty similar, right? They're abstruse subjects involving deep expertise where there can be landmines and hidden messes that can have great consequences. That's why you have due diligence.

    Yup, that's the standard view, Due Diligence 1.01. It's even all reasonable … except for Venture Capital investing in tech companies.

    Due Diligence for computer and software technology

    The vast majority of tech due diligence involves fairly large companies with large staffs. When you're looking to do a deal with a fairly large tech company as the target, it's business as usual. You want to make sure everything is done to industry standards. There are probably security and other regulations. Are they in compliance? Are they following industry-standard development methods, or is there some kind of willy-nilly, out-of-control stuff going on? Do they actually have a QA process that assures that new software releases won't go belly-up and hurt the company and its customers?

    This sounds pretty much like legal and financial diligence. Because it is!

    Tech Due Diligence for VC's

    How can a VC responsibly invest in a young software-based startup without understanding the software? Most investors aren’t programmers, after all, and can’t “see” the software. No big deal! VC’s usually aren’t lawyers or accountants either, after all, and there’s a standard solution: hire an expert to perform due diligence. Hire lawyers for all the legal things, accountants to pour over the books, and technology due diligence people to handle the tech. Now that wasn’t much of a problem, was it?

    There's just one little problem: the standard methods for evaluating software lead to terrible results. This shouldn’t be surprising, because the standard methods for building software lead to terrible results! If the industry’s best minds can’t figure out how to build software effectively, why would anyone think that these best minds would be any better at evaluating software and the organizations that create and maintain it?

    You won’t find these industry-leading groups and thinkers wringing their hands or wailing lamentations at their on-going failure – that would be bad for business! So instead, awfulness is accepted as just how things are. So when experts evaluate software groups, the typical process is to compare them to how the vast majority of groups “get things done” – kinda, sorta, eventually, with failures and massive security breaches attributed to some combination of life and the existence of evil criminal masterminds. If the group fails to sing the standard songs and say how wonderful the software dances that are currently in fashion make them feel, then questions are raised.

    Large corporate and government organizations know and accept all this. They take comfort in striving to attain industry-standard “best practices,” and give presentations about how great their direction is. They may put signs up on walls, or hang banners making vague but strong assertions about “innovation” stuff involving the future.

    What if you’re a small organization, a start-up or not much more advanced? For the VC point of view, this makes little difference. They tend to have due diligence providers with solid methods and a track record the partners of the VC firm are comfortable with. This fact of existence leads to a few major behaviors among entrepreneurs:

    • Avoid any VC that wastes your time putting you through what you know to be irrelevant evaluations
    • Hold your nose and go through with it, while trying to gull the evaluating firm into thinking you're more industry-conforming than you are, and to the extent that you're not, you're planning to fix it all up real soon
    • Really change things so that you match industry-standard evaluations, often by hiring a tech leader who's "been there done that."

    Many VC's pride themselves on their judgment of character, and won't take the tech due diligence really seriously anyway — experience has taught them that it's mostly a pile of irrelevant gobbledy-gook anyway. They place their bets on the company leaders, whether they have the vision, drive and smarts to create a winning company, or at least to achieve lift-off.

    This is a real problem, but it logically reflects a larger problem in the tech industry, one that I've tried to articulate in a variety of books and blog posts: there is a huge gap between how the vast majority of software organizations build software and how the most effective small ones build it, not unlike the difference between army draftees just out of basic training and a team of elite Rangers. They both fight, but if made to fight each other, it wouldn't be a "fair" fight. Same thing with software, only even more so.

    The vast armies of software engineers, armed with their impotent and irrelevant Computer Science degrees, resemble draftees out of basic training more than anyone would like to admit. There are so few software Rangers that most of the plodders rarely encounter one. Rangers certainly don't hang out by the water cooler hoping to chat with one of the sloggers — a real Ranger wouldn't want to enter the building, much less be employed there.

    The very best tech due diligence for VC's attempts to differentiate between these cases, which aren't totally distinct:

    1. The company develops software following industry standards.  If what they're doing is amazing and pretty much already baked that could be OK.
    2. The company isn't following standard norms or any other norms. It's just disorganized. This is a problem. There's a risk in whether it can be fixed. Know what you're dealing with is essential.
    3. The group is not following industry norms, but is achieving rapid progress with good quality using non-standard methods — not anything-goes wild-west, but non-standard techniques that are actually methods. There is a wide range here, which must be judged.

    The trouble of course is that standard, off-the-shelf tech due diligence conflates cases 2 and 3 above. Truly effective tech diligence for VC looks for case 3, and judges to what extent the company achieves it.

    Conclusion

    Performing effective tech diligence is pretty similar to financial and legal diligence — unless you're investing in a break-the-rules, innovative startup or young company and you're a VC. In that case, you're best off judging them by different standards than you would normally use. In finance and legal, you're looking to find things that are unusual and diverge from norms — because they could be bad and hurt you. In tech, you're looking for things that strongly differ from standards and norms — specifically methods that trump those standards and norms. You don't want a group that fails to live up to standard army discipline. You want a group that chooses to do things differently — because they do them better, WAY better. That's what makes winners, and that's what VC's want to invest in.

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