The Financial Model Challenge in Tech Due Diligence
It’s no secret that the current economic climate is challenging. Rising interest rates, higher costs, and prolonged fundraising cycles have created a tough environment for startups and investors alike. The M&A world is feeling the squeeze, and nowhere is this more apparent than in the financial models being presented during Tech Due Diligence (DD).
Fundraising is tough across the board. Startups are struggling to secure capital, venture capital firms are facing the same difficulties, and even Fund of Funds are finding it hard to attract investors. In this climate, startups need to be more capital efficient than ever before. It’s not just a good-to-have—it’s a requirement for survival. No matter your story or situation, you’re unlikely to be the one in a million that breaks this rule. That’s just the reality of the market today.
Capital Efficiency: The New Imperative
Back in 2021, things were different. Money was flowing, and the financial models we saw were often detailed and narrative-driven, reflecting ambitious growth and innovative thinking. Even then, there were areas for improvement, but the creativity and potential in those models were palpable.
Fast forward to today, and the landscape has changed dramatically. Startups must now play the hand they’ve been dealt with caution. The best strategy, if we continue the poker analogy, is to play tight: limit losses, control expenditure, and run lean. Surviving is more important than anything. Yet, despite the obvious need for meticulous financial planning, we’re seeing financial models that simply don’t stack up.
What we’re seeing in 2024’s Financial Models: Where It All Goes Wrong
In many cases, the financial models presented in Tech DD are failing to meet even the basic expectations. This is surprising, given that Tech DD is often the final piece of the puzzle, a last-minute addition to the diligence process when the deal is almost certain to go through. Yet, even in this late stage, the financials are lacking, particularly in technology-driven companies. Here’s what we’re seeing:
- Stagnant Technology Budgets: Many models show a flat technology budget, with no scaling of tech spend to match projected growth. It’s business as usual, with no mention of a necessary uptick to support scaling operations. This is not a compelling investment narrative.
- Neglected Tech Team Growth: Companies are projecting significant revenue and customer growth, but with no corresponding increase in tech team capacity. For example, we assessed a firm with over 1,200 employees and a 20% projected growth in headcount, yet no planned changes to a slim IT team. This lack of alignment is worrying.
- Underinvestment in Tech Maturity: Areas like cybersecurity are often neglected, with companies essentially marking their own homework. A fractional Chief Information Security Officer (CISO) or equivalent could provide much-needed oversight, but such roles are often absent from the financial model.
- In-House vs. Fractional Talent: There’s a tendency to try and handle everything in-house, even when a short-term, fractional solution would yield better results. This approach can lead to inefficiencies and missed opportunities for optimisation.
- Disconnect Between Financials and Tech Strategy: We’ve seen founders present financial models in DD meetings, only to struggle when questioned about the tech strategy. One AI firm, for instance, had a working product and plans for new models, but no provision for R&D. This disconnect is a red flag for investors.
Tech as a Cost Centre: A Flawed Perspective
In many cases, tech is still being treated as a cost centre rather than a driver of value. Without tracking the outcomes and demonstrating the value created, it’s impossible to make a compelling case to investors. In today’s environment, where fundraising is already an uphill battle, this oversight can be fatal.
It’s disheartening to see management teams go through the grueling process of fundraising, only to stumble at the final hurdle. But what can be done?
Raising Awareness and Bridging the Gap
The first step is to raise awareness. Founders and management teams need to understand that the financial model is not just a box-ticking exercise—it’s a critical element of the investment narrative. It should reflect a clear strategy for growth, capital efficiency, and technological scalability. Our Value Creation Partner, Simon Ratcliffe, talks about tech budgets in this informative BrightTALK video,
What’s Next?
You tell me. Whether you’re an investor, founder, or advisor, there’s a role to play in improving the quality of financial models and ensuring they accurately reflect the realities and opportunities of the tech landscape. It’s time to get real about financial models and build narratives that not only survive due diligence but thrive in it.
