Back in the dim days of the 19th century, businesses relied on daylight and gas lamps to illuminate their world. The gas companies became huge because they offered the best commercial alternative, and, as a result, the streets of the major cities became a web of gas pipes that traveled under streets and branched off into homes and factories extending the day and accelerating the industrial revolution.
Out of this haze came a man with a vision of how this need for light could be enhanced and improved by technology. Thomas Edison had the vision to see the alternative to gas lighting. He would start a company to generate electric power that would be cheaper to produce and provide a cleaner, brighter source for illumination. He formed the Edison Electric Light Company in 1878, with a syndicate of leading financiers who advanced him $30,000 to form the Edison Electric Light Company, which eventually became known as General Electric.
Investing in technology companies has always been a risky business. When Thomas Edison sought investors for Edison Electric, he had to first convince them that his new product, the electric light, would someday replace the oil and natural gas lamps they were then using. He had to sell his investors on a vision of the new technology sufficiently to get them to invest money when others were not able to envision a city strung out with electric utility poles. The history of technology investing is a history of risks taken and opportunities seized. There are, of course, many more who took the risk and lost. Was it just luck or were there hidden traits that could have helped investors to mitigate their investment risk?
Ability to Deliver
How are investors assessing technology companies today to determine if they have the ability to succeed? More and more, investors are asking whether or not the company has the supporting infrastructure to develop, produce, and deliver products profitably. Edison did not simply show his investors a burning light bulb; he demonstrated that he had the ability to deliver the electric power to light a city and to deploy an electric lighting system that contained all the elements necessary to make the incandescent light practical and economical. He had to demonstrate to his investors that he had a company infrastructure in place that would allow him to charge customers by the kilowatt hour and make money from the invention.
Mitigating the risk associated with technology investment requires assessing a company's ability to profitably produce and sell products. In general, the first attraction of an investor to a company is the product itself. The gadget attracts them. The assessment of technology companies, however, requires due diligence that looks beyond the product and assesses the capacity of the company to bring its ideas into production profitably with minimal risk.
Due diligence assessments require an analysis of three distinct facets of the company. These three unique views of the company are all needed to determine the legal status, financial status, and the technical status of the company prior to investing. Technical due diligence includes the assessment of the company's technical infrastructure. The term technical infrastructure refers to more than the engineering processes and procedures used for hardware and software development, manufacturing, and production. It's not limited to the "product side of the house." You cannot divorce these functions from the sales, marketing, and operations functions that are also required to fulfill an order and are therefore components of the cost of the product. Technical due diligence is used to assess all of the operational procedures that form the complete infrastructure of the company. Technical due diligence assesses how well the company has formalized how they do business.
Investors today will perform a technical due diligence as well as a financial and a legal due diligence to determine if the company has the ability to support its projections. Many companies with great ideas do not have the capability to bring the product along the entire path from concept to production.
Study in Diligence
The following case study is provided to demonstrate how the value of an organization can be increased by adding infrastructure to improve the quality of its products.
Fig. 1 Three Due Diligence Views of Company
One of the clients that I have worked with is a document imaging company. They grew from a small startup technology company into one of the most recognizable brands in the document imaging market.
From the company's inception, they have been profitable and earnings have been regularly put back into the company to support their growth. The down side of this approach is that it also limited the growth of the company to what it was able to support from within. This allowed the competition to catch up and encroach on their markets. As a result, the owners decided it was time to consider an outside investor. From a financial and legal due diligence standpoint, the company was well positioned. They had no debt, and a lot of market traction. There were no legal actions, and they had agreements in place with all suppliers and channel partners.
They conducted a customer survey to get feedback on how the company was viewed by the market. The results showed that they had a problem in the areas of product reliability and quality. Not a surprise since they had never had a quality assurance (QA) department. In their early days when there was little or no competition, the products were very innovative and most customers were glad to have a solution. As the competition started to grow, however, the company did not change their competitive strategy, and they continued to compete by delivering newer, more innovative products. Product quality was not keeping up and therefore would be seen as a risk by investors during a technical due diligence. They were able to solve this problem by making improvements to their infrastructure.
Traditionally, the R&D Department had done its own testing and products were released from R&D directly to the customers. The Product Support Department then answered the calls from angry customers when bugs were found in the field. Turnover in the Product Support Department was high because the support staff had very little control over when and how fixes were made to the products. R&D was being driven to produce new products and maintenance of existing products did not receive priority and took a long time to get fixed. They changed the legacy software release process to include a QA function.
The company changed their product release process such that R&D passed the products to Product Support who took on the new responsibility of QA testing. This made sense because Product Support had to answer calls from upset customers, so they would have a great incentive to rigorously test the products. Products were only released after Product Support agreed they were ready. As a result of adding QA testing to the operational infrastructure of the company, product reliability went up measurably. Product reliability and quality rated high in the next customer survey. This meant lower risk for an investor and, therefore, a higher potential valuation for the company.
Define Your Culture
I have had the ability to work with both investors performing due diligence and with companies preparing for due diligence. My company, Diligent Consulting, specializes in technical due diligence preparation and assessment services. Across these companies, one trend seems clear; technology companies that work as hard to establish their infrastructure as they work at developing their technology have a greater chance for success. The infrastructure the companies establish defines their culture as well as the methods they will use for conducting business. This is what investors are looking for when performing a technical due diligence. Infrastructure maturity has a direct impact on the long-term success of a company, and investors are using technical due diligence as a tool to help lower their risk with these investments.
Between 1999 and 2000, I spent a year living in Singapore and traveling to China, Malaysia, and India working with both U.S. companies interested in manufacturing products in Asia and with a large number of Asian investors interested in investing in U.S. technology companies. The U.S. companies were typically looking for lowcost off-shore manufacturing facilities and rarely asked questions about the methods that would be used by the Asian manufacturer.
The Asian investors, by contrast, seemed to be very familiar with concepts such as ISO-9001, and regularly asked questions about the ability of the U.S. companies to meet these standards. ISO-9001 is an international standard that defines the criteria for assessing the quality infrastructure of a company. U.S. companies seem to have been slow to adopt standards like ISO-9001. These are critical infrastructure definition tools when conducting international business and are now being recognized for their value in the United States. Investors often use this standard as a guide for assessing risk during a technical due diligence.
SPIE Professional: What's the most common due diligence mistake companies make?
Jim Grebey: The most common mistake companies make is not envisioning that the day will come when they will need to go through a due diligence. The owners of a company usually have an exit strategy in mind. Whether it’s an IPO (initial public offering), an M&A (mergers and acquisitions), or a venture partner coming in to generate liquidity for the founders, it’s important to have a vision of what the company should look like when an investor is asked in.
From a technical due diligence standpoint, this means that the company is prepared for and has an infrastructure in place to support future growth. Most businesses get bogged down in the day-to-day details of conducting business. They are probably working hard to grow the business revenue, but if they have 10 employees, they’re not necessarily thinking about what it would mean to run a business with 20 or 30 employees needed to support this growth.
During due diligence an investor will ask questions like: how will you manage your growth? The ideal answer is to demonstrate that you already have these management processes in place. If an investor sees a great product but little ability to produce it in the volumes necessary to meet the projections, they may still be interested in investing but will assess risk and lower the valuation. I ask my clients to describe what the ideal situation would be to maximum value at the exit, and I work for an answer that leads them to the next level of growth.
It takes at least two years to mature the infrastructure of a company that does not have controlled policies and procedures in place. Early planning and a continuous process improvement program are necessary to improve the valuation and minimize the perceived risk to an investor. Having a vision of the end goal helps managers achieve this goal.