How to Run a Technical Due Diligence: The Fine Prints
The last of our three-part series on running an end-to-end due diligence process. Today we look at what usually happens once the DD is done, and your company approaches the closing of the deal
Hello,
This is the third and last article in the series about running a technical due diligence, a task many of you will have to perform at some point in your career.
If you missed the previous articles, I do recommend you go back and read them in order, as what we’ll be discussing here assumes you’re familiar with the concepts introduced there.
If you’ve already read them, then you’ll know what you need to get started with and what the key aspects are you need to cater to as you go through the actual process of evaluating a company for a potential merger or acquisition.
Before we get into the core of the article, a bit of housekeeping. Sudo Make Me a CTO is a reader-supported publication. I publish most of my content for free, but I’ve recently started the monthly Something Big Is Happening1 series reserved for paid subscribers. If you want to help and support the work that goes into writing this newsletter, please consider upgrading your tier. And if you can’t, I’m glad you can continue reading most of the content for free.
Back to the article.
In this last chapter, we’re going to look at what happens once a decision to proceed is made. This decision usually takes place over multiple iterations, with a committee of people tasked with the responsibilities of evaluating all the findings, agreeing on a purchase price, and then deciding to move on with signing agreements.
There is a lot of legal work that needs to happen at this stage, and we won’t get into the details of all of them for a couple of reasons: I am not a lawyer, and you’ll likely rely on your colleagues with the right expertise to handle them. Therefore, we won’t be talking about the Letter of Intent (LOI), Non-Binding Offer (NBO) or the Term Sheet. We’re happy to know they exist, and leave it to the experts.
There are a couple of legally binding agreements where your involvement as the one in charge of the technical aspects of the acquisition is fundamental. One will require an involvement from your side that makes you effectively a co-owner, while the second one will mainly require your input to be watertight and comprehensive.
These two documents are, respectively, the Transition Service Agreement (TSA) and the Share Purchase Agreement (SPA).
Let’s have a look at both, starting from the one that will require a significant contribution from your end, the TSA.
The Transition Service Agreement (TSA)
To understand the purpose and need of the TSA, we need to first look at the timeline of what happens during an M&A transaction, when a digital company or a part of it changes hands and is transferred from the current owner to a new owner.
We’re going to resort to databases and distributed systems analogies to understand it better.
From a financial and legal perspective, the change of ownership is atomic and happens under the paradigm of strict consistency: as soon as the deal is signed, the entity belongs to the new owner. Think of it as a synchronous database transaction.
But on a technical and operational level, things are significantly different. The process through which the acquired company stops depending on the services provided by their former owner and is fully integrated into the new structure follows the pattern of eventual consistency. It’s a long-winded, complicated distributed transaction. The overall system needs to be able to continue operating while the transaction completes. In other words, we can stop the world and wait for it to execute.
In order to ensure that the systems eventually converge and that they keep functioning effectively while the complex transformation is ongoing, you resort to defining a very detailed Transition Service Agreement. This is an agreement that spells out the details, obligations, requirements and guarantees that the two parties need to commit to ensure a smooth transition.
It might sound a bit too abstract, though I’d expect most of you to find database analogies very concrete. To make it even more real, let’s look at a concrete example.
Let’s assume your company is acquiring another business. This business is currently owned by a conglomerate with many such operations in their portfolio. Unless they’ve been running each operation fully isolated and independent2, chances are that there is a whole set of services that are mutualised across all the companies within the group: HR Information Systems (HRIS), ERPs and CRMs, or Authentication/Single Sign-On Systems. You might find shared production infrastructure, SRE teams or cybersecurity services and functions. You'd be better off assuming you'll find some weird dependency that can't be easily removed.
A naïve approach would assume that all these systems can be migrated with a couple of clicks as soon as the deal is closed; no big deal.
But we all know that migrating those systems is a very delicate, cumbersome and often lengthy process. You will need to rely on the selling company to keep maintaining those services until you’re able to disconnect from them. And you don’t want to have all the managers breathing down your neck every day, asking when the migration will be completed.
That’s when the TSA comes into place, as it’s intended to define exactly the terms of the migration that will take place once the deal is closed. And given that you’ll likely be in charge of part or all of that transition, it’s paramount that you are involved and in charge of ensuring that the TSA is built around comprehensive, realistic and clear assumptions.
Each M&A process lives a life of its own, but in your contributions to the TSA you should ensure it properly covers the following aspect:
Scope of the transition: This is where the work done through the DD to map out all the systems and their dependencies will come in handy. You need to ensure that the TSA covers every single system that will not transfer immediately and will need to stay operational after the deal is closed. No matter how small, or whether it might seem simple to handle, you want it to be listed. Remember, this is a legally binding document, not a gentlemen’s agreement between friends.
Timeline: The TSA has a clear beginning and end. The overall agreement usually lasts for 12 or 18 months, depending on the complexity of the work required to completely detach the operations. Within the TSA, though, you’ll want to detail specific timelines for individual services or groups of services. In other words, you do not necessarily want the selling company to keep delivering the entirety of the services until the end of the transition. You should lay out an incremental plan for progressively reducing the scope of the service provided as you make progress through the transition.
Responsibilities: This might sound obvious, but it’s better to make it explicit. It’s essential to be explicit on who is responsible for what exactly, especially when the business you’re acquiring has a lot of dependencies in different branches of the same organisation. Your responsibilities too will need to be made explicit, namely your commitments in completing the transition within the agreed-upon timeline.
Costs: This complex transition won’t happen for free. The selling entity will want compensation for keeping the services alive and operational while you complete the detachment. Costs will typically be broken down and grouped based on service typologies or affinities or on a per-service basis. There are always overhead costs associated with operational burdens that tend to span beyond a single service, such as compliance/cybersecurity/incident management, etc. The cost aspect is another reason why you want to plan your TSA for progressive exit so that as you proceed, the monthly cost will decrease.
SLAs: For all the services covered and billed through the SPA, you’ll want detailed and comprehensive SLAs with explicit penalties for breaches. These are there to ensure aligned incentives between the selling and the buying parties, as the monetary rewards or payments are tied to ensuring a reasonable quality of service.
While the legal team is ultimately responsible for the final version of the TSA, and while other areas will be necessary to its definition, most of the work to be done during the transition period will be directly or indirectly under your responsibilities. Make sure you collaborate proactively with your legal counterparts to ensure that you and your team can deliver on those commitments.
Once the due diligence phase is completed, your focus should be mostly geared toward the TSA. But the DD might have uncovered some aspects that you will want to be addressed by another agreement, the Share Purchase Agreement (SPA)
The Share Purchase Agreement (SPA)
While the TSA defines what happens once the deal is closed, the SPA is a list of prerequirements for the deal to happen. While at its core it’s a legal and financially heavy artefact3, you might need to contribute to it in some form.
In particular, if your findings in the due diligence highlighted high-risk situations or major issues with certain areas, such as compliance or cybersecurity, you might want to include remediations as part of the pre-agreement process. That’s particularly important, as liability will transfer to you from the moment the deal is signed.
In other words, you can use the SPA to ensure you won’t inherit a situation that could represent a serious legal or operational risk for your company.
The specifics will vary from case to case, and common examples have to do with compliance, cybersecurity risk, or major structural gaps.
As an example, you might uncover serious gaps in the way Personally Identifiable Information (PII) data is handled that represent a serious violation of GDPR or similar regulations. Or you might become aware of a tight dependency with a third-party vendor which might represent a serious continuity risk, etc.
What matters isn’t the specific but rather making sure that for those high-risk cases clear conditions and remediations are included in the SPA document so that they’ll happen before the risk is transferred to you.
But be prepared to be told that your conditions can’t be included in the SPA, as they could jeopardise the whole deal, especially in cases where there is a strong appetite for it among your leadership. The best thing you can do in such cases is to flag the risk formally and ensure it’s formally accepted, i.e., taken responsibility for, by whomever the ultimate decision-makers are.
One final remark. While technically the SPA covers what happens before the deal and the TSA what happens after it's closed, both documents are usually worked on at the same time and need to be ready for the closing to happen.
What Happens After Closing?
If all goes well, and many things can go wrong in such complex processes, your company will close the deal, and the ownership of the target business will be transferred over.
This is when the transition work outlined in the TSA starts.
So, while most of the leadership will celebrate the major milestone, you’ll be looking at a few months of hard work just to cut ties with all the existing dependencies in the guts of the selling company.
This can be a long and either engaging or painful journey, mainly depending on how mature and structured your organisation is. Regardless, it’ll be a wonderful opportunity to learn new skills that are extremely valuable in the industry.
With this we’re ending our series on the tech due diligence process. I do recommend you bookmark these articles, as I’m pretty sure you’ll end up needing them at some point in the future.
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This is often the case with PE-owned companies investing in a very diverse collection of industries and businesses. If you're dealing with such a case, consider yourself lucky, as the work to be done on your end will be easier.
Honestly, you probably do not want to read the whole document unless you're into legal porn