Selling Your Technology Company: Five Ways to Kill the Deal
This article is part 3 of a 4-part series. In two previous articles, I reviewed the overall process of selling your tech company, and then discussed what you can expect during due diligence.
While most acquisitions will involve due diligence around legal and financial issues, more and more transactions include IT due diligence -- a deep dive into the technology supporting or in some cases largely defining the business.
This series is focused on selling technology companies, so we’ll review some of the issues that, if discovered in a thorough IT due diligence effort, can derail your deal. Before you even consider selling your company, you need to be sure none of these situations apply to you.
Software Licensing and Ownership Issues
If the acquiring company discovers unlicensed software, this can lead to a number of negative consequences. If the cost to properly license the software is too high, the deal price may be reduced or the deal may be killed because the financials no longer work. The buyer may also be concerned about the possibility of an employee reporting you to one of several software trade groups that provide a reward for software piracy whistleblowers. Finally, you can look either incompetent or dishonest to a knowledgeable investor.
Many small companies utilize outside consultants to develop all or part of their software when they’re starting out. If a proper work-for-hire agreement isn’t in place, the ownership of the software or source code can be uncertain. Your buyer may discover this and make it a prerequisite of the deal that you get your contractor to explicitly sign over the rights to the software. This can be a difficult or uncomfortable situation at any time, but especially on the eve of closing your deal where it means much more to you than to the contractor.
Security / IT Infrastructure
Many industries and business transaction types have specific security and regulatory requirements -- HIPAA in healthcare, Sarbanes Oxley in finance, PCI for credit card processing, etc. It’s not unusual to find companies started by entrepreneurs with business experience in relevant areas, but without knowledge of the security and technical issues mandated for their industry.
They then hire software developers and DBAs who also don’t have the industry-specific security knowledge. This can result in a disaster during IT due diligence when these major gaps are exposed.
In healthcare, for example, it’s not uncommon to find small companies where the developers have not taken HIPAA best practices for security and data encryption into account when designing technology solutions. A savvy investor will evaluate the cost to remediate this situation, which again can end up as a significant purchase price reduction or an all-out deal killer.
Employee Issues
Do you have any skeletons in the closet when it comes to your employees? If so, you can be sure they will be identified during due diligence. At least some of your existing employees will be interviewed, and the person performing due diligence will know the right questions to ask.
Do you have non-compete agreements in place for at least your key employees? The time to do so is not while you’re in the process of selling your company, and they have you over a barrel.
Are there any key employees on medical leave? It’s surprising how often this turns up. I’ve seen more than one situation where the main architect of a company’s software was on medical leave with no hope of returning.
Are you the subject of the any existing or pending lawsuits involving past employees? Such a situation has a potentially high cost associated with it, and can make your investor think twice.
General Deficiencies
There are some miscellaneous issues that can, under certain circumstances, rise to the level of killing the deal.
More than one IT due diligence effort has determined that the target company had a complete lack of domain knowledge. Some companies receive all product ideas from large customers. A potential acquirer won’t view that as a long-term model for success.
Do your customer and supplier contracts take into account a potential change of control or contract assignment? If your largest customers can hold your deal hostage, it’s going to make your buyer think twice about your company.
Do you have all of your source code available? You’d be surprised at how often companies are running a key internally developed product or supporting technology without access to the source code. The company never had it because the tool was developed by an outside party who didn’t provide it, or it was lost in a computer or server crash.
Are there scalability issues with your software? Many technology company transactions are based on the economics of significantly expanding the acquired company’s user base. If IT due diligence discovers that your systems can’t support ten or more times the number of current users without a major rewrite or other investment, your deal may be in jeopardy.
How have you accounted for the costs of your software development and maintenance? Accounting principles have very specific guidelines for how to handle these expenses. If you haven’t had the advice of a good accountant, your numbers may not be as good as you think they are.
Flat-Out Lies
Don’t expect to get away with complete fabrications about your company.
I’ve seen companies for sale that touted huge numbers of website registered users and high Web traffic statistics. Five minutes of good IT due diligence can tell if these numbers are real.
Expect that the backgrounds of owners and key employees will be checked. A senior software developer at a company being acquired had a resume full of inaccurate employment history and college degrees. With today’s easy access to information, these misrepresentations are simple to find.
I once saw a target company’s deal PowerPoint that listed 25 customers as users of a newly-launched product. In reality, there were fewer than five. Even a cursory IT due diligence effort can uncover this.
Conclusion
If an investor finds a serious issue during IT due diligence, they may be concerned enough to walk away from the deal, and if not, they may want to reduce the price of the deal more than is necessary to address this single issue, since they’ll wonder if others exist.
The best way to identify these problems before you sell your company is to look at it as an investor would. IT due diligence checklists are available online for free. Use them to objectively evaluate your company. Is your company one that you’d want to buy? If not, get to work addressing the issues you discover.
Be sure to read part 1: When to Expect When Selling Your Technology Company
part 2: Selling Your Technology Company: The Due Diligence Process
