How to Prepare Your Startup for Investor Tech Due Diligence

The term sheet is finally in your hands. The worst is over, isn’t it? Not so fast, as you receive another email stating that the technology due diligence review of the startup will commence in three weeks. For a non-technical founder who doesn’t have a CTO on staff, this is often where fear begins.

Indeed, technical issues could lead to a decrease in valuation by up to 20%, but that's not all nearly 60% of investment deals fail due to discovered problems during the technical assessment.

But here’s the catch: you don’t need any technical expertise to ace this test. All you require is a strategic approach to preparation.

What Is Investor Tech Due Diligence?

Tech due diligence for investors means that investors will carefully analyze your software, processes of developing the product, as well as the general IT infrastructure. As opposed to the financial due diligence that is focused on your financial statements and tax reports, tech due diligence that comes right before the investment deals with the quality of the product. For the purpose of deciding on whether or not to invest, investors will hire external specialists and companies that will analyze your source code.

What Triggers a Technical Due Diligence Request

A request for a technical due diligence checklist is most often triggered by a funding round or an acquisition offer. The level of scrutiny scales with the amount of money being invested. While a seed investor might only care that you have a working product, a Series A investor will look closely at whether that product can handle ten times its current traffic.

The 7 Areas Investors Audit

Investors do not conduct this technical due diligence process on their own. They bring in an independent third party or experienced CTO to conduct the assessment and review. They focus on finding out any potential “deal-killers,” which will be too expensive or risky to resolve later.

Code Quality and Tech Debt

To put it simply, tech debt involves cutting corners during development to make future modifications more challenging and expensive. In essence, it is like a high-interest credit card where the benefit of adding a particular function comes quickly at the cost of reduced speed in the future. Investors are interested in knowing whether their money goes towards scaling an existing product or redeveloping it entirely.

A startup technical audit often reveals that code built by offshore freelancers or small agencies lacks consistent standards. If your code is a "spaghetti" mess, it increases the risk that new hires will struggle to understand how anything works.

Code Quality checklist:

• Ensure the investors have convenient access to your GitHub or GitLab repository.
• Add a README file that outlines the purpose of the product and how a new developer can work on it.
• Provide evidence of using a uniform coding style (PSR for Laravel, the correct linting for React Native, etc.).
• Note any outstanding critical bugs and unpatched security vulnerabilities.
• Ensure that every member of your development team, including previous contractors, signed over intellectual property rights to your company.

System Architecture and Scalability

Your investors aren't investing in your current self, but in your future potential. Architecture assessment makes sure that your product can support ten times the amount of users and keep running smoothly.

They will be searching for "single points of failure." In other words, if one server or service goes down, then your entire product is jeopardized. If your application uses a contemporary stack, such as Node.js or Laravel, then your database and hosting (AWS, Google Cloud, etc.) would need to be evaluated to determine their ability to cope with increased loads.

Checklist for Architecture:

• Make a simple visualization of the flow of information.
• Define your cloud infrastructure and hosting.
• Define your database technology and its scalability.
• List all single points of failure and explain how you will mitigate them.
• Provide the results of your most recent load/performance testing.

Security and Data Privacy

Startup security audit covers the security measures adopted to handle user data. In addition, it also covers adherence to various security guidelines, such as the one provided by OWASP. Finally, it involves compliance with laws, such as GDPR and local laws on data privacy.

Security audit check list:

• Ensure encryption of all user data in the database and while transferring the data through the Internet.
• Adopt role-based access, ensuring that all employees access only required data.
• Note any incidents of security violations or data breach.
• Create a policy related to security and implement it within the organization.
• Audit third-party developer access and revoke access rights to former contractors on servers.

Intellectual Property Ownership

This is the primary concern when using offshore developers or companies. The investors demand concrete evidence that you own the intellectual property. What if the code was written by an individual but never transferred through an intellectual property agreement? That individual would own the most valuable asset of your company.

IP Ownership Checklist:

• Acquire signed intellectual property transfer agreements for each person involved in writing the code.
• Look for any copy-left software licenses (GPL) that require you to release your proprietary code.
• List the design elements (logo, user interface kit), which should be owned by the company.
• Highlight any pending patents or litigation concerning your intellectual property.

Engineering Team and Process

They need to make sure that you can carry out your plans. The audit team will look at how well you are able to coordinate processes and code from the developer's machine to production. They will be interested in the professionalism of work and not working independently and randomly.

Checklist for Team and Processes:

• Prepare the organizational chart of your team that includes third-party contractors.
• Describe how you use task management software such as Jira, Trello, or Notion.
• Explain how you deploy and test code before releasing it.
• Provide your approach to testing and whether it is manual or automated.
• Include information about the continuity plan for offshore team management.

Documentation and Knowledge Transfer Risk

A key concern for investors is the "bus factor": can your company continue operations without your lead developer? A technical assessment for potential investors includes verification of documents necessary for the quick replacement of staff.

List of documentation requirements:

• Ensure API documentation for both internal and external APIs.
• Generate runbooks with instructions for system operation and maintenance.
• Publish an introductory document for new developers.
• Document a product roadmap aligned with your company objectives.

Third-Party Vendor and Licensing Risk

Most products nowadays require APIs from external sources and use Software as a Service (SaaS). Investors will be interested in whether your product will break down if a third-party company stops operating or modifies its pricing.

Third-Party Risk Checklist:

• Identify all third-party vendors your product is using (Stripe, Twilio, AWS, etc.).
• Verify that there are commercial licenses available for all software used by your team.
• Locate all "critical path" vendors with no reliable way to back up in case of failure.
• Check the monthly costs of these vendors to see if it fits your business model.

How Long Does Technical Due Diligence Take? (Timeline by Stage)

The timing of conducting due diligence varies depending on how complex your technology is and how much money you are raising. MVP testing could take a couple of days, while preparing for Series A tech diligence could take several weeks as the process entails a deep examination of your source code and architecture.

According to data from companies such as Kruze Consulting, timeframes increase considerably as the amount at stake grows.

At least one thing is consistently noted by Kruze Consulting among funding rounds: Investors investing significant resources, namely 40 hours or more into diligence, achieve returns of about 7.1× on their investment, compared to 1.1× when they invest less than 20 hours. Due diligence is not simply a formality – it is how a serious investor safeguards his or her funds.

If you have a term sheet and are reading this article, refer to the table to learn your funding round. It is how much time you have to prepare. This week.

The Non-Technical Founder's Preparation Plan (4 Weeks Before Due Diligence)

Founders usually wait for the checklist of the investor before getting ready. This is wrong since it will cause hurried documentation and may result in missing any danger signals. Having one month to get ready for the auditing process, you will be able to organize your technology stack, and the auditing will become a formality.

The PlusInfoLab company has been assisting startup founders in Canada, Australia, and the United Kingdom for more than seven years with this problem of timing. Our experience shows that an organized virtual data room can provide an investor with confidence despite some defects in the codebase.

Week 1 : Gather and Organise

The initial seven days aim at tracking down all bits of your company’s digital footprint. You cannot fix something you do not see.

• Audit all code repositories: Ensure you can access all the source codes stored in repositories like GitHub, GitLab, and Bitbucket that are employed by your current and past development teams.
• Audit all contractor agreements: Collect all agreements and contracts for every individual or agency working for you previously and now. Look for an exact phrase called “IP Assignment” proving your ownership of the created work.
• Map out all dependencies: Compile a list of third-party services utilized in the operation of your product.
• Organize rough notes: Compile all the information stored in some rough Notion pages or Slack messages containing the deployment instructions for your app.

Week 2 : Fix the Paper Trail

Legal & Security Hygiene in week two includes addressing the problems that cause the investor's fear.

• Signature of missing intellectual property paperwork: In case you come across a developer who hasn't yet signed the assignment agreement, ensure they do it. That is usually why deals fall through.
• Removal of access to the systems: Assess the server and database access rights. The developer should not retain access to the system anymore if they are no longer working on the project.
• Discovery of open-source license restrictions: Search for libraries that carry strong open-source licenses such as GPL.

Week 3 : Get an External Technical Review

This is the area where most non-technical founders get under tremendous stress. The best approach to identifying gaps is to perform a stress test by bringing on board a fractional CTO or a third party company.

In our experience at PlusInfoLab, we have audited Laravel, React Native, and Node.js stacks. We provide you with a comprehensive document in writing about the issues identified in terms of security, architecture, and code quality which you can then show to your investor.

Week 4 : Prepare the Data Room

In the final week, convert your preparation into a proper presentation that impresses the investors. The well-organized Virtual Data Room reflects professionalism and that your company is developed enough to take the investment.

• Set up your VDR: organize your documents neatly in folders in either Google Drive, Notion, or DocSend.
• Add the essential information: upload your system design diagram, signed IP documents, technical team organizational structure, security policies, and the external audit report of week 3.
• Test all links: check that all documents open smoothly, and that there are no issues regarding permissions.

Common Red Flags That Kill Deals and How to Fix Them Before the Review

Investors are looking for reasons to say "no." If your audit turns up a major security hole or a legal mess over who owns your code, they will often walk away or slash your valuation by up to 20%.

Here are some typical issues identified during the technical due diligence of your company's investor, along with solutions you must solve before the audit starts.

Do You Need a Fractional CTO or a Tech Agency to Pass Due Diligence?

In most cases, a startup relying on freelance developers will require professional assistance to perform its technical audit. The choice between hiring a fractional CTO and a dedicated development agency depends on the nature of the gaps detected.

The role of a fractional CTO is to represent the technology aspect of your business in the process. A fractional CTO is a person responsible for providing an overview of your software's architecture, which helps make your startup appear more reputable during the discussion with an investor. Understanding how a fractional CTO works for your investor presentation is crucial if you don't have a technical co-founder.

As for a development agency under contract, it's a practical solution to the problem. A CTO identifies issues, whereas a development agency deals with them, fixing vulnerabilities, improving the documentation or making sure there aren't any problems from the code perspective.

If you face challenges in justifying the decisions made regarding your technological stack, you probably need a fractional CTO. However, if the problem lies in the structure of your code or the lack of documentation, both roles should be considered.