Technology investments - Beware of snags
Preparing a direct investment into a technological company is somehow thrilling. Emerging technologies have the power to blow away any competition with radically new business models and disruptive forces. New technologies have the potential to generate very attractive revenues with double digit growth rates. And since the project is often carried by enthusiastic characters the due diligence process is also entertaining.
However, the technology also has the power to smartly re-name any business-as-usual. The technology has the power to blur simple pictures who would otherwise look perfectly clear. Pseudo-scientific statements have the ability to convey illusions and to sell dreams-come-true solutions. Setting the red line between the feasible and the fantasy requires sometimes a very sharp understanding of the facts.
Above all, the technology is a discipline with its own rules. The Technology Due Diligence process is difficult as it must cover the value of the intangible assets. Those intangible assets may be a strong contributor to the disparity between company value, either as per accounting records or as per market capitalization, depending on which valuation method is chosen. Understanding the value of intangible assets in the context of a technological company requires a method and an appropriate understanding of the technology.
Review those 5 items for a systemic mitigation of the risk:
- Screening of the management team. A direct investment is usually engaging for a long term relationship, so the individuals must have the ability to carry the project with the required integrity, on the long run. On top of it, the management team must be perfectly knowledgeable in the considered area of technology. Being able to build and industrialize the technology, being able to shape its marketing and to sell it requires a lot more than just a quick understanding. Running a technological company requires more than a mouth full of buzz words and jargon built phrases. How to recognize the real McCoys? Dig, dig and dig again until the picture is clear. And remember that, as a result from the investment, the current management team may be altered.
Running a technological company requires more than a mouth full of buzz words and jargon built phrases
- Screening the Intellectual Property (IP). The IP section is a tough one: a patent protection is a way for the investor to feel protected. But the substantive laws of all the jurisdictions do not apply the same way. Under the USPTO (United States of America) a correctly drafted software or algorithm patent can be granted, even if, since recently, business method patents are now invalid and the USPTO has begun denying several software algorithms and other method patents. Under the EPO (European jurisdiction), computer programs is not legally patentable as such. Nevertheless, the fact that an invention is useful in business does not mean it is not patentable if it also solves a technical problem. So it is challenging to understand how much protection there is behind a patent request. This brings to a second point, where the patent request is only a request. Prior to being published, there's a long period of uncertainty (18 month under EPO or PCT) during which a competing patent may somehow pop-up from unexpected, and steel the prior art. And finally, A patent does not necessarily give its owner the right to use the invention subject to the patent. Many inventions are improvements of prior inventions that may still be covered by someone else's patent. If an inventor obtains a patent on improvements to an existing invention which is still covered, he is only allowed to use the improved invention if the patent holder of the original invention gives permission. So holding a patent is also not a guarantee that the owner has the right to use the full span of the claimed invention. On the other hand, a company may have developed skills that place them ahead of the competition. It is important to recognize those skills and organize the company's strategy accordingly.
- Screening the documentation. Among the assets to be carefully reviewed is the quality and completeness of the documentation. The way it is structured and presented says a lot about how much the company values its technology. The documentation is multiple and variable, depending on the type of technology considered. Because the cemetery is full of indispensable people, the documentation must be done in such a way as to survive the founders of the company. Making an investment into a company who doesn't have the memory of its foundation is just like placing a bet only on individuals.
- Screening the third party certificats. Different technologies have different types of mutual recognitions. Because the said technology, at some point, interferes with either adjacent or complementing technologies, because the technology is meant to go out to either industrial or consumer applications, different standards or regulations apply in regard to its usage. Again, different jurisdictions mean different rules and different standards. It is a good practice to review the targeted geographical range of the technology and make sure the appropriate recognition is ensured. Hint: a recognition by a third party always consists of an auditable certificate.
- Screening how the technology works. Depending on the status of the company regarding its technological promise may be perfectly acceptable to check the functionality on a mock-up. But the sharp eye must be able to understand the value of the missing part. In the case of a technological company the technology is the lumbar support of the business which deserves a very serious assessment. A third party recognition can be helpful in the process of understanding what it is all about and where this company stands in its process. Seed funding and early stage investments may face serious risks if the technology is not clearly understood. Later on the assessment is made easier: The proof of the pudding is in the eating.
I have gone through numerous cases of Technology Due Diligence during my career. The purpose of setting those 5 topics during the Technology Due Diligence is to check how all the items are balanced in regard to other ones.
I have seen, for example, a company with a tremendous amount of third party certificates, which inherently brought a lot of confidence during the early discussions. But it turned out that there was no real documentation, the how-it-works lacked of clarity and the management team who was initially brilliant, started to loose its shine when digging into the patent grants, until we figured out that the certificates were either fakes or not valid.
The opposite situation also crossed my way, with absolutely brilliant management team, a very valid IP statement even though not patented, beautifully well documented, certified and working products. The only point is that they were too busy at their technology to make money, which eventually almost caused the company to collapse. This was a typical case of a company having 80% of its value outside of its P&L.
Beyond the strict screening of the 5 topics mentioned above, the due diligence must also cover other items like the intersection between the technology and the market requirements and the status of the considered technology related to its lifecycle, not to mention the financial and legal situation of the company, of course.
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