Risk or crown jewel: how to read technology during technical due diligence

We all know that technical due diligence on a startup or scale-up can delay a deal, undermine it, or increase its value. For example, when it exposes code that has been built too quickly, security vulnerabilities or IP that hasn't been transferred properly. Or, conversely, reveals a codebase that is exceptionally well-structured. Problem identification is also not the same as problem assessment. As a Venture Capitalist (VC), how do you decide whether any of the above should delay or stop a deal or actually justifies a higher offer?

The assessment process consists of four steps: recognising (red, amber or green) flags, weighing the context, valuing the crown jewels and establishing whether the technology does what it is supposed to do and aligns with the company objectives: fit for purpose. Although we are using development patterns as an example, the same process applies to other key assessment areas including security vulnerabilities and IP issues.

Step 1: are there any signs of anything affecting the foundation of the technology?

Can anything be found in the technology that ought to stop the deal or lead to a renegotiation? In the case of development patterns, we look at the share of AI-generated code. It is particularly relevant during technical due diligence because the pace of development often outpaces documentation when generating code with AI. A high share of AI code is not automatically a problem, but it is indicative of an increased risk of no-one knowing how the code is structured anymore. A sign is not a verdict; it’s a reason to seek clarity.

Step 2: how to weigh a sign within the context of the tech company’s plans?

Is a sign really a problem in the deal at hand? The answer to this question depends on one thing: what is the investment candidate planning to do if the investment goes ahead? If it’s planning to recruit engineers, the sign of a high share of AI code can suddenly be very problematic. New developers must be able to read the codebase. If code lacks clear architecture and proper documentation, they won’t be able to because there’s no-one who can explain why it was built the way it was. If there are no short term plans to scale up the technology, this sign is a concern at the most, not a deal breaker. The context determines the weight of a sign; the sign itself does not.

Step 3: are there any crown jewels that justify a higher offer?

During a technical due diligence, you need to assess risks but also consider what is well-structured. Which strengths are there from a technical point of view? Are those crown jewels worth the investment? A clean, well-documented codebase is strong, not vulnerable. And that’s a reason to invest or it may even justify a higher valuation and offer. Make sure your checks cover the entire codebase. A carefully selected sample provided by the considered tech company can skew the picture.

Step 4: can the technology support the company’s growth ambition?

The fourth and final step relates to what might be the most important question for a VC: does the technology align with business objectives and can it support the growth the company has in mind? If steps 1 to 3 don’t reveal any problems, you might find that the architecture works well in a demo but not at the scale envisioned by the company. If it isn't possible to scale up the architecture, the company's value development could stagnate as a result. Step 4 identifies this risk before the deal is signed.

Good technical due diligence determines the deal terms

Four steps, one outcome. This process generates a well-founded answer to the question of whether there is a risk that could delay the deal or calls it into question altogether. And also, whether the risk in question really is a deal breaker in the given context. In addition, it determines whether the technology has a ‘hidden treasure’ that actually justifies an increase in the deal value. Clarification is achieved too on whether the technology will be able to grow in line with the company's ambitions and objectives.

Not all outcomes and signs are black-and-white. If all flags are green, the term sheet can be drawn up or the offer increased. If the process does reveal a risk, this allows room for a renegotiation, additional terms or the decision not to proceed with the deal at all.