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The Sell-Side Imperative
This is the first of three blog posts to highlight Noremo’s approach to Tech Due Diligence; the opportunities and the pitfalls.
Starting the year on an optimistic note, we’re going to look at how Tech DD from the sell-side can maximise your valuation as you approach an Exit.
Like all these things most Private Equity investors don’t engage in a transaction unless they have a fairly clear idea as to how they intend to exit within a 3-5 year timeframe. However, soon enough after the deal completes all notes of optimism strategised in the investment thesis collide with the cold reality of real world business. In the uncertain times after a change of ownership key people leave, customer decisions are delayed, implementation timelines stretch and geopolitical events sometimes butt in.
Here’s a story of one such PE firm “Elementary” and its portfolio company, “Scaleup Ltd.” (fictional names - both made up!).
By the end of Year 1, Elementary’s Operating Partner and Scaleup’s CEO have got things back on track and are starting to forge ahead with their Value Creation initiatives. Scaleup is stepping up its sales efforts in new geographies, investment in its new subscription service is starting to bear fruit and the prospects of a couple of Buy & Build deals of companies in adjacent business spaces look do-able.
By the end of Year 2, Operational Efficiency is the new mantra. Scaleup’s CFO is looking to squeeze every extra ounce of margin. Nice-to-have Tech experiments in AI unless there is tangible ROI are no longer getting indulged, the annual Christmas entertainment has been cancelled. EBITDA uplift is the new holy grail. This is the time Elementary’s Investment Partner is starting to have conversations with the Mega-Funds, a few Corporates, and several M&A banker friends from yesteryear to gauge the levels of interest that are out there to take Scaleup to the next stage under PE ownership or to join Mega-Brand as its new strategic growth division or dare-we-say it, stand on its own feet with an IPO.
All the while, the Tech Debt mountain held on servers next to the office canteen and triplicated across Scaleup’s virtual estate on software repositories across multiple Cloud vendors that has been allowed to grow unmanaged and untrimmed. Decay has begun. That knowledge will either lay hidden for future business owners to uncover at their peril or the information gets shared! Although the interests of the group might be better served by timely information sharing, too often human instinct is to cover-up and gloss over.
If you have a demoralised Tech team where the best people have already left and the new leadership team have not yet had a chance to fully get a grip on Scaleup’s software and infrastructure estate, then you Elementary, Scaleup’s primary investor are truly exposed. By the end of Year 3, when Elementary thought they were going to be signing term sheets on another successful disposal at Enterprise Value of 14x EBITDA, you now face the prospects of holding out for another 2-3 years until “market conditions improve” or selling in a hurry to a sharp Secondaries operator.
What happened was that Elementary’s preferred suitors conducted detailed Tech Due Diligence on Scaleup and uncovered all these Tech Debt challenges, multiple fissures in Scaleup’s Cyber defences and a series of antiquated, multiple overlapping enterprise systems, largely manual and often duplicate business processes. And each of these suitors were demanding such aggressive re-pricing that Elementary was not even going to recover its Cost of Capital; let alone make its required Internal Rate of Return.
“This is unheard of!” screamed Elementary’s Founder and Managing Partner. “Scaleup is not even a Tech company!!!” He’d clearly spent too many hours carving up the world in Davos and had missed that famous Satya Nadella quote from back in 2019 when he proclaimed “Every company is a Software company!”1 or needs to think like one.
Rather than Tech Debt being ignored and any knowledge of it swept away in the Tech team redundancies that happened at the end of Year 1, the wiser course for Elementary (and Scaleup) would have been to treat Tech as a first class priority from Day 1 after the acquisition and to have a plan for managing Tech Debt that was somewhat grounded in reality.
If that didn’t happen then it’s never too late to get started. As part of your Exit Preparations or Vendor Due Diligence, the next best action will be to engage external specialists to take an outside-in view of your Portfolio Company’s Technical Architecture and Cyber Security, Risk & Resilience setup. That’s where Noremo brings specialist expertise. Noremo would conduct an assessment that identifies major Tech and Cyber risks. Noremo would then assist Scaleup to create a prioritised Tech Roadmap and Risk Register so that high risk issues can be addressed immediately and lower risk issues addressed over time.
From an investment timeline perspective, it’s not important that all identified Tech risks are addressed immediately - the list will be too long. What is important is that your PortCo now has that Tech Roadmap and Risk Register, that the first 2 or 3 Tech risk milestones have been successfully achieved, that PortCo has a realistic plan to complete the others and that Scaleup has now embedded a Risk Management process to consider and prioritise new Tech risks as they emerge on an ongoing basis. “Remove the friction to Exit.”
If you as an Investor can manage to do that then your chances of success are going to be measurably higher. In the words of the great Orlando Bravo “Always be Selling… Always be Buying”. After all it’s the business transformation that counts over the long term.
In the next articles we’re going to cover:
* Sell-Side
* Buy-Side
* Tech Strategy
Image credit: Google Gemini Nano Banana Pro
Footnotes:
1. https://www.satellitetoday.com/technology/2019/02/26/microsoft-ceo-every-company-is-now-a-software-company/