Software due diligence in Investments, Mergers & Acquisitions: Key considerations and risks

Any Private Equity (PE),  Venture Capital (VC) or Organisation involved in investments, mergers or acquisitions will have established their own formal approach to Business Due Diligence. However, while these established due diligence processes used to revolve mostly around Financial Due Diligence (FDD), as more and more companies are becoming reliant on software, and software becoming one of the most valuable assets in many orgnasations it’s prominance in due diligence process has naturally become a priority. 

One of the biggest risk areas for M&A in tech deals is software plagued with vulnerabilities or that contains open source license compliance issues. That’s why software due diligence is crucial not only in M&A but any form of investment, as it allows acquiring or investing companies to assess the quality of the target company’s software assets, and address (or at least plan for) any risks before finalizing the deal.

This process ensures that the software assets of a company are evaluated thoroughly before making any financial commitments. In this article, we will delve into the nuances of software due diligence, its significance for private equity and venture capital firms, key aspects to consider, how to perform it, and how The Code Registry can assist in this crucial process.

Software Due Diligence

What is software due diligence?

Software due diligence is a comprehensive evaluation of a company’s software assets during an investment, merger, or acquisition process. It involves assessing the quality, security, compliance, and scalability of the software to identify potential risks and opportunities. This evaluation helps investors understand the true value and potential liabilities associated with the software, ensuring informed decision-making.

Typically, this process is carried out by the company considering the M&A or investment. However, internal software due diligence is often completed before an IPO or M&A. The level of detail on a software due diligence project can vary vastly on a case by case basis, often dictated by the level of investment or significance of the software on any deal. 

 

Why Software Due Diligence is a key consideration for Private Equity and Venture Capital firms?

You would be hard pushed to find any valuable company in the current business world that didn’t have some form of software critical to it’s business operations. Whether thats a website, mobile app, customer portal or internal operations tool – software is now one of the most valuable assets a company has alongside its customer data, cash and physical assets.

Therefore for private equity and venture capital firms, the software and technology element of any due diligence project is paramount as it will include:

  1. Risk Mitigation: Identifying and mitigating risks related to software quality, security vulnerabilities, and legal compliance prevents costly surprises post-investment.
  2. Value Assessment: Understanding the value of software assets helps in negotiating better deal terms and ensuring a fair price.
  3. Strategic Alignment: Ensuring that the software aligns with the strategic goals of the investment or acquisition, supporting growth and scalability.
  4. Regulatory Compliance: Ensuring that the software complies with relevant laws and regulations, avoiding potential legal and financial repercussions.

If each of those elements are covered then it will provide confidence to the investing or acquiring party that the software element of the deal is robust and furture proofed.

Key aspects of software due diligence

In order to ascertain whether the 4 considerations above are met, the key aspects that make-up a complete software due diligence report will need to include full assessments of:

1) Code Quality

A complete analysis of the codebase will be required to ascertain the full make-up of the code. Being able to document the basics around coding languages, maintainability, readability, and technical debt allows the potential investor or acquierer to understand future potential. By also having an assessment of the quality of the code itself you can get a good indication of whether significant future investment will be needed to bring the software up to standard, or if it is in-line with current expectations. The simply fact is, is that well organized and high-quality code is easier to maintain, debug, and extend, while sub-standard code can be challenging, slow and expensive to maintain.

2) Security

In the context of software and code security what an investor or acquirer really needs to be aware of are  ‘known vulnerabilities’ within the software itself. These vulnerabilities refer to well-documented and recognized weaknesses or flaws in software that have been identified and reported by security researchers, developers, or the software community. These vulnerabilities are documented in databases and repositories, making them “known” to the public. Security professionals actively track and share information about these vulnerabilities to help developers and organizations address and patch potential security risks in their software. 

The security element of a software due diligence report is essentially letting the investing company know the potential security risks, which in turn again will be informing them how much further investment is going to be needed to remove these threats. 

3) Licensing and Intellectual Property

Verifying the legality of software licenses and ownership of intellectual property is another way of saying “does the company legally own or have the correct licenses for all software involved in the final product?”

This element of the due diligence report will include details of any third-party dependencies and open-source software alongside their versions and compliance stipulations. This is important to have documented as improper usage can result in legal liability and financial issues.

Similar to IP and open-source components, it’s critical to understand the software’s dependencies, including any external libraries, frameworks, or services. Dependencies are typical, but over-dependence can create risks if they become unsupported or introduce security risks.

4) Developer History

While it may not seem hugely important for a potential investor or acquiring company to have visibility of which developer has worked on what code. The truth is, is that being able to see this data over the lifespan of a companies software can provide hugely informative. If for instance you can see that a single team has worked across the software for. anumber of years and contributed the vast majority of code – you can be confident that the knowledge of the softwares intricacies are still within the organisation. If however, you can see there have been multiple teams of people, passing the softwares development between them over a number of years it would be fair to assume there will be a dilution of coding consistency, best practices and complete knowledge – meaning potential risks around bug fixing, maintenance and future build costs.

5) Code Value

Valuing code or software can be a complex process that involves both objective and subjective considerations. While the value of a codebase or piece software can vary depending on different factors, including its functionality, quality, demand in the market, and potential for future development it is an important metric to have to hand when seeking investment or negotiating an acquisition. 

Really what an investor or acquiring company is looking for is evidence that the software matches the value that the company states. This might be that the software has been built specifically around the companies services or operations. In order to achieve this you need a breakdown of the code – what’s been written, if it is custom or open-source, how many languages are present, the level of complexity and if there are outdated components. All of these areas will contribute to being able to place a value on the software to feed into the overall diligence report.

There are certainly other elements to evaluate when considering investments or M&A opportunities, but the above aspects are at the heart of what’s essential for actionable software due diligence. Once complete, a potential investor will understand what they may be getting involved with.

How to perform software due diligence?

Significant investments, M&As, and IPOs typically necessitate thorough due diligence, considering both software and the company itself. On the other hand, software companies may wish to run internal due diligence before an external party so they can take corrective action for any areas of concern.

So, how do you conduct due diligence, either on your own company or a potential investment? Let’s break down the overall process to help you get started.

Performing software due diligence involves a systematic approach:

  1. Initial Assessment: Gather basic information about the software, including architecture, technology stack, and documentation.
  2. Code Review: Conduct a detailed review of the codebase to assess quality, security, and maintainability.
  3. Security Audit: Perform a comprehensive security audit to identify vulnerabilities and recommend mitigation measures.
  4. License Review: Verify the legality of all software licenses and check for potential intellectual property issues.
  5. Performance Testing: Evaluate the software’s performance under various conditions to ensure scalability and reliability.
  6. Compliance Check: Ensure the software adheres to relevant industry standards and regulatory requirements.
  7. Reporting: Compile a detailed report highlighting findings, risks, and recommendations.

But how can you collate this data, either as the Investor or as the company? Especially if you don’t have in-house technical specialists. 

One option would be to engage with an independent tech due diligence specialist (of which there are many). These consultancy practices tend to have a robust mix of highly technical consultants and will use a variety of analytical tools to produce a complete software due diligence report for either side of the negotiations. The main downside of these firms is they are generally very expensive and often cover more than is required. 

The other option is to start with a Comprehensive Software Auditing tool like The Code Registry. Tools like The Code Registry can act as a more affordable self-service solution for collating all of the critical information you need either as the investor, acquiring company or company being evaluated. By performing this as a first stepyou can often bypass expensive consultancies altogether as the information and analysis  provided covers any diligence requirements.

Using The Code Registry to Perform Software Due Diligence

As mentioned, The Code Registry is well-equipped to perform comprehensive software due diligence. Our platform provides:

  1. Automated Code Analysis: Utilizing advanced AI to scan over 4,000 rules and data points, ensuring a thorough evaluation of the codebase.
  2. Security Assessment: Identifying and addressing security vulnerabilities to protect your investment.
  3. Compliance Verification: Ensuring the software complies with relevant laws and industry standards.
  4. Full developer history: Analyzing the complete history of commits, contributors and changes over time..
  5. Detailed Reporting: Providing clear, actionable reports to inform your investment decisions.

 

Software due diligence is a vital process in the M&A landscape. Understanding its importance and executing it effectively can safeguard investments and unlock potential value. By leveraging The Code Registry, private equity and venture capital firms can make informed, confident decisions, mitigating risks and maximizing the value of their investments.

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