Expert Guide to Technical Due Diligence for Startups

1. Introduction to Technical Due Diligence

What is Technical Due Diligence?

Technical due diligence is a comprehensive evaluation of a startup’s technological capabilities. It evaluates a company’s IT network, software and applications, infrastructure, cyber security and data privacy controls.

It is most commonly used by investors (such as venture capitalists, family offices and investment managers) who are seeking assurance that a startup is technically sound. It’s essential to assessing the viability and risks of the technology underlying a business. For startups seeking private equity investment, technical due diligence is a critical step in demonstrating their readiness and value.

Why is Technical Due Diligence Crucial for Startups?

technician in lab coat performs technical due diligence on motherboard

Risk Mitigation

Investing in a startup is risky. Through technical due diligence, potential investors are able to identify and mitigate risks associated with the target company’s technology. The process will uncover vulnerabilities, technical debt and improvement areas, ensuring a more data-driven and informed decision around whether or not an investment is wise.

Investment Readiness

It costs between £20,000 – £100,000 for a venture capitalist to perform technical due diligence (depending on the size of the transaction). Consequently, you know if a startup has reached technical due diligence, they are being formally considered as a potential investment.

Cultural Fit

It’s not all about the outputs from the due diligence…both companies (venture capitalist and startup) will learn a lot about how each other work and operate by virtue of going through the process together.

Lightbulb Icon Key Takeaway

The due diligence process itself acts as a mechanism for transparency and an informal way for each to assess whether there might be a ‘cultural fit’ too.

Driving Business Value

Technical due diligence provides an opportunity for the startup as well as the potential investor. By identifying and addressing technical weaknesses early, startups can; improve code quality, underlying IT infrastructure and privacy/security controls. This can lead to greater scalability, boosting investor confidence, higher valuations but also, winning more clients.

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2. Key Elements of Technical Due Diligence

Infrastructure and Architecture Review

Assessment of Current IT Infrastructure

A thorough review of the startup’s IT infrastructure is performed. This will evaluate any physical network (if it exists) and cloud environments such as AWS (Amazon Web Services), GCP (Google Cloud Platform) or Microsoft Azure. The goal is to assess both whether the infrastructure is robust, secure and compliant, but also whether it is capable of supporting commercial growth (should investment be made).

Scalability

Scalability is a critical factor for startups looking to grow rapidly. The infrastructure must be able to handle increased loads and adapt to changing business needs, especially if investors are about to pump a load of cash into the business Assessing the flexibility of the system ensures that it can integrate new technologies and scale seamlessly and efficiently.

Code Quality and Maintainability

Code Reviews and Technical Debt

Code quality is a significant indicator of a startup’s technical health, especially where the company is a SaaS (Software-as-a-Service) product. Depending on the calibre of software engineers the startup has used to date, code quality could potentially be a big challenge that takes some time to rectify. Often in the early days of growing businesses, code quality suffers as founders focus on getting afloat and winning contracts.

PC Desktop on a table being subjected to technical due diligence

Conducting code reviews will identify technical debt, which can hinder future development and increase maintenance costs. Investors will be keen to identify any areas which might increase operating costs as this will affect profitability.

Coding Standards & Best Practices

Adhering to best practices in coding standards (such as OWASP Top 10 critical vulnerabilities) is fundamental for ensuring a high product quality. Code that aligns to industry standards and is well-documented facilitates quicker development sprints, faster product releases and easier onboarding of new software engineers as the team grows.

Case Study Icon Case Study

TechNova, a mobile app startup, caught the attention of GlobalTech, a major tech company. This was due to its innovative approach and growing user base. GlobalTech discovered numerous issues with the code quality. These included high technical debt, lack of documentation, inconsistent coding standards, numerous bugs, unsecured data storage and weak authentication. These problems were severe enough for GlobalTech to halt the acquisition. The cost of fixing them outweighed the potential benefits.

3. Cyber Security

The Role of Cyber Security in Due Diligence

Protecting Sensitive Data

Cyber security is a cornerstone of technical due diligence. There isn’t an investor out there that is keen to deal with a significant data breach of a company they have just acquired. Protecting customer data (names, addresses, emails, etc.) and personally sensitive data (sexual orientation, political views, health data, etc.) from being lost to cyber attackers is key.

This includes accidental data loss by a careless employee and is crucial to maintaining client trust and regulatory compliance. An effective cyber security strategy that is well implemented, safeguards company and customer data, ensuring the security of the business.

Compliance and Regulatory Requirements

Startups must comply with various regulatory requirements (e.g. UK Data Protection Act, FCA/PRA for financially regulated entities, etc.) depending on their sector, types of data they process and country of origin. Ensuring compliance with these regulations during due diligence is crucial to avoiding legal complications and potential fines from regulators such as the ICO (Information Commissioner’s Office).

Cyber Security Assessment Checklist

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The venture capitalist will likely bring in an expert due diligence partner such as CyPro to perform the required checks. The cyber security assessment will follow a standard industry best practice framework, such as ISO 27001, CIS 18 Critical Controls, NIST, OWASP, etc. However, to give you a flavour for the types of cyber controls that will be assessed, see below.

  • Network Security – evaluates the security controls in place to protect the startup’s network infrastructure (on-premise or cloud environments). This includes firewalls, intrusion detection systems and network segmentation.
  • Application Security – assesses the security of applications in use or being developed. This involves reviewing the software development lifecycle, vulnerability management, and secure coding practices.
  • Secure Software Development Lifecycle (SSDLC) – SSDLC makes sure that code is developed securely by following security and privacy-by-design principles from start to finish. This includes establishing controls such as static security testing, container scanning, developer training and code repository access controls.
  • Data Encryption and Protection – ensures that data is encrypted both at rest and in transit. Assess the methods used for data protection and the policies in place for data access and storage.
  • Incident Response and Disaster Recovery Plans – reviews the startup’s incident response and disaster recovery plans. These plans should outline steps for detecting, responding to, and recovering from security incidents.

4. How Technical Due Diligence Will Work

There are 4 key stages to how the due diligence exercise will be run, from pre-diligence prep to reporting the findings.

STAGE 1: Pre-Diligence Preparation

  • Documentation Gathering – there will be a document request and ask to share securely to secure file share. The due diligence partner will collect relevant technical documentation (e.g. Secure Coding Guidelines), system architecture diagrams and security policies. Comprehensive documentation is crucial for an accurate assessment. They may even ask for direct access to platforms such as your GitHub code repository.
  • Internal Self-Assessment – before you begin the formal due diligence process, it is well worth performing a pre-audit self-assessment. If you don’t have the capacity or expertise in-house, use a an expert company like CyPro or a subject matter expert/contractor. This self-assessment gets all the skeletons out of the closest before the venture capitalist arrives and finds things that will later be used to decrease your valuation. You want to uncover any possible problems before they are formally identified.

STAGE 2: Initial Assessment

  • High-Level Review of Systems and Processes – performs a review of systems and processes to identify any immediate red flags and typically guides the subsequent detailed analysis.
  • Identify Red Flags – big ticket items and warning signs such as outdated technology (e.g. out of support operating systems), lack of documentation or governance, or poor security practices.

STAGE 3: In-Depth Analysis

  • Detailed Code Review – conducts a thorough evaluation of the codebase (if a SaaS product) to assess code quality, maintainability, and adherence to best practices. This step is vital for understanding the technical debt and future scalability of the product(s).
  • Security Vulnerability Testing – performs security vulnerability testing to identify technical weaknesses. This includes both automated scanning (e.g. Nessus scans) and manual testing methods (penetration testing) to ensure comprehensive coverage.
  • Capacity / Load Testing – the whole idea of investment is to grow a business. So, what’s the point investing in a business that cannot scale quickly? None. This phase tests the scalability of the IT infrastructure to ensure it can handle this commercial growth. This involves stress testing, capacity planning and testing to evaluate how the system responds under load (e.g. simulating a high number of website visitors or application users after a launch day).

STAGE 4: Report

  • Creating a Detailed Due Diligence Report – the findings (good and bad) will be drafted into a report that outlines the strengths and weaknesses uncovered during testing. The report should be shared with founders and technological leads to check for factual accuracy well before it is shared with the prospective investors.
Lightbulb Icon Key Takeaway

Ensure this report is converted into an actionable roadmap of improvements to address the identified issues. Often completing key milestones on this roadmap is made a condition of any later investment ‘term sheet’ (legal commitments and conditions of an investment round).

5. Tools and Techniques for Technical Due Diligence

Automated Tools for Code Analysis

  • Static Code Analysis Tools – static code analysis tools such as SonarQube and Checkmarx can automatically review code for quality and security issues. These tools provide valuable insights into the codebase, highlighting areas needing attention.
  • Dynamic Analysis Tools – dynamic analysis tools like OWASP ZAP and Burp Suite test applications in runtime, identifying vulnerabilities that static analysis might miss. These tools are essential for a comprehensive security assessment.

Cyber Security Tools

  • Vulnerability Scanners – scanners such as Nessus and Qualys help identify security vulnerabilities that could be exploited by cyber attackers. Regular scans are crucial for maintaining a secure environment.
  • Penetration Testing Tools – penetration testing tools like Metasploit and Kali Linux are often used as part of a penetration testing exercise to simulate cyber-attacks in a controlled manner. It will assess the operational effectiveness of security controls. This human-based and proactive approach helps identify and address vulnerabilities before they can be exploited. If you need a penetration testing team to support or advise, CyPro provide expert penetration testers.

6. Common Pit-falls

  • Fixing Technical Debt – implementing strategies to manage and reduce technical debt, such as code refactoring, operating system decommissioning or upgrading. Processes need to be established which prevent technical debt accumulating over time and then becoming unmanageable.
  • Integrating Security into Agile Development – integrate security (and privacy) into the agile development process by incorporating DevSecOps practices into each product sprint. This approach ensures that security is not an afterthought but an integral part of development.
  • Communicating Findings to Non-Technical Stakeholders – don’t assume everyone understands the output of the due diligence report. Some are written really poorly! Simplify technical jargon. Create an executive summary pack specifically for board of directors or existing shareholders.

7. Conclusion

Startups need to do thorough preparation and self-assessments before technical due diligence commences to reduce risks and ensuring that any negotiations around valuation aren’t impacted.

This involves identifying and fixing vulnerabilities, technical debt, and areas that need improvement. It demonstrates investment readiness, showcasing a startup’s commitment to transparency and willingness to tackle potential issues, making it more attractive to venture capitalists.

Improving code quality, infrastructure, and security controls can help startups drive their own commercial success by winning more clients, making them more scalable and potentially, more valuable.

Looking Ahead

The landscape of technical due diligence and cyber security is continuously evolving. New trends like AI code analysis, automated compliance checks, and advanced threat detection are already changing how due diligence is done. Startups need to keep up with new advancements and be ready to incorporate them into their operations. Continuous improvement and adaptation are important for staying competitive and growing in a complex digital world.

8. Additional Resources

Books

1. “The Art of Scalability: Scalable Web Architecture, Processes, and Organizations for the Modern Enterprise” by Martin L. Abbott and Michael T. Fisher – a comprehensive guide to building scalable and maintainable systems, including insights into technical due diligence processes.

2. “Technical Due Diligence for Startup Technology: Evaluate the Need for Early Exit, Delayed Exit, and Growth” by Sandeep Agrawal – this book gives tips for investors and entrepreneurs on how to do technical due diligence on startups. It’s focused on details.

3. “Code Complete: A Practical Handbook of Software Construction” by Steve McConnell – this book provides valuable tips for coding, essential for evaluating code quality during due diligence. It offers insights on best practices.

Articles

1. “The Importance of Technical Due Diligence in M&A Transactions” by McKinsey & Company – discusses how technical due diligence is important in mergers and acquisitions, focusing on key areas and best practices.

2. “Technical Due Diligence: Key Considerations and Common Pitfalls” by TechCrunch – an article discussing the critical elements of technical due diligence and common mistakes to avoid during the process.

3. “A Guide to Technology Due Diligence in Private Equity” by EY – explains how private equity firms review technology, with helpful tips and strategies for due diligence.

Papers

1. “A Framework for Technical Due Diligence in Software Startups” by Peter Vogel, Max von Zedtwitz, and Roland Faber – outlines a structured approach to conducting technical due diligence in software startups.

2. “Evaluating Technical Debt in Software Systems: Research and Practice” by Philippe Kruchten, Robert L. Nord, and Ipek Ozkaya – examines technical debt and its impact on software quality.

3. “The Role of Cybersecurity in Technology Due Diligence” by the National Institute of Standards and Technology (NIST) – a comprehensive paper on the importance of cyber security in due diligence processes, with guidelines and best practices.

9. FAQ

What is Technical Due Diligence?

Technical due diligence involves thoroughly assessing a company’s technological strengths and weaknesses. This process examines the company’s IT systems, software, infrastructure, cyber security and data privacy measures and reports back to both the startup and potential investors.

Investors, including venture capitalists, family offices, and investment managers, primarily use this exercise to ensure a startup’s technical robustness. It is crucial for understanding the feasibility and potential risks associated with a company’s technology. For startups aiming to secure private equity investments, technical due diligence is a vital step to prove their preparedness and worth.

Technical Due Diligence Checklist?

We do not advise standard checklists as it invariably leads to missing out key areas of control or governance.

The areas to check during due diligence vary heavily on a number of factors including;

– The actual technology in use (Windows, Linux, iOS, Android, etc.)
– Underlying IT infrastructure (on-premise data centres, GCP, AWS, Microsoft Azure, etc.)
– Where the company is physically located (UK, US, Europe, UAE, Asia, etc.) as well as where it operates (sells its services) determines what regulatory and law applies.

If you have any questions please get in touch with us.

Technical Due Diligence Report Sample PDF?

We can provide a sample (free of charge) due diligence report in PDF form if you are interested. Please use our contact form to request this.

How to Prepare for Technical Due Diligence?

The best thing you can do is a pre-audit self-assessment (assuming you know what benchmark or industry standards you’ll be assessed against).

If you don’t know or don’t have the capacity to do in-house, please get in touch and we can support.

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Published
May 29 - 2024
Author
Jonny Pelter
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