Technology due diligence: the need for and benefits of technology assessment in connection with investment in high-tech companies.

• Author: Goforth, Carol R.

It seems like technology is in the news on a daily basis, particularly the financial news. First, technology investments "skyrocketed," (3) with technology companies serving as the "darlings of the investment community." (4) Then, in mid-April of 2000, the "tech-heavy Nasdaq market plummeted," losing percent of its value. (5)

This volatility in the public markets means a tougher ride ahead for technology companies, and not just those whose stock is already publicly traded. Venture capitalists are backing away from technology deals, with the consequence that some companies are unable to secure adequate funding for their operations. (6) Meanwhile, merger and acquisition activity in the tech-area continues to boom, with billions of dollars at stake. (7)

In these times of market volatility, technology due diligence is a concept of potentially critical importance. Companies desperate for additional sources of financing need a way to convince investors that their projects have real value. Venture capitalists and other potential investors need a way to investigate such claims. Businesses seeking potential merger partners must be able to evaluate the underlying value of the target company. Lawyers and other professionals involved in these deals have disclosure and other obligations which require them to be able to make good faith estimates about the nature of these companies' businesses. (8)

Without the ability to independently demonstrate or investigate the viability of technology projects, investors will not have the information necessary to support sound investment decisions. Technology-based companies may find it impossible to attract needed investment because their products or processes are poorly understood. Professionals retained to provide advice in connection with the financing of these deals may face the risk of lawsuits claiming that they made false and misleading statements about the technology. (9) Finally, the public sector is also likely to make very poor business decisions unless technology claims can be investigated, because of the government's continuing commitment to support the development of new technologies. (10)

This article will describe the concept of technology due diligence in some detail, and will contrast it with the types of due diligence traditionally conducted in connection with investment in new and emerging companies and the acquisition of more developed enterprises. It will also examine how the divergent interests of potential investors and the proponents of new technologies increase the need for technology-based assessment. In connection with this analysis, this article suggests a paradigm shift in which technology due diligence becomes an accepted requirement any time investment in or acquisition of a technology-based company is proposed or considered. The article also considers the ways in which technology due diligence can benefit each of the different interests at stake when considering investment in a technology-based venture. It will conclude with a suggested approach for evaluating technology due diligence proposals, to insure that the due diligence will be appropriately conducted.

1. WHAT IS TECHNOLOGY DUE DILIGENCE?

   When presented with an attractive business opportunity that is based on sophisticated new or evolving technology, anyone with less than expert knowledge of that technology will need help to fully appreciate the risks involved with technology and its use in the business venture. Anyone who fails to undertake a due diligence assessment, which includes a competent analysis of the underlying technology, may unsuspectingly invest in a superficially attractive but ultimately impossible enterprise. Similarly, a company that fails to acknowledge and respond to the risks inherent in new and developing technologies may be unable to attract needed investment or may find itself exposed to potential liability for claims made in connection with the issuance of securities. (11) Investment professionals (12) may offer inappropriate advice or fail to give adequate warnings if the risks are not fully appreciated or articulated. The public may find its tax dollars being wasted and desirable technologies being underdeveloped if risks are not accurately assessed. These risks will be known only if an objective assessment of the technology is included as a fundamental and integral part of investment due diligence. In order to fully appreciate these needs, it is important to re-evaluate the meaning of certain essential terms.

   1. Defining Technology and Technology-Based Enterprises

      Why is it important to define such a commonly used word as "technology?" For those not directly involved in technology, at least in any way other than the use of the commonplace, there has been a considerable loss of precision in its definition. The word "technology" is being both overused and inappropriately used -- it has become a buzzword to lend an air of currency and a certain mystique. This misusage compromises the clarity of communications when the word "technology" is used, unless a careful definition, devoid of unintended connotations, is provided.

      For the purposes of this article and the concepts addressed here, "technology" is defined as applied science, that is, natural science and the scientific method applied to solving practical problems. It usually involves at least the potential for commercial exploitation, and certainly when one focuses on the need for technology due diligence, this will almost always be the case. Natural sciences, in this context, may include agricultural sciences, biology, chemistry, earth sciences, medical science, mathematics, and all fields of engineering. The social and political sciences are not included. This definition obviously leads to the question of what constitutes a "technology-based" enterprise.

      Because technology is evolving so rapidly, it is not possible to identify "technology-based" enterprises by simply providing a list of qualifying tools, resources, or techniques. Today's conventional photocopy machine, now commonplace in virtually every office, was considered by some to be cutting-edge technology as recently as twenty years ago. The typewriter preceded it in a similar way. As a consequence of the rapidly changing nature of what we consider to be technology, we must use a more systematic and generic characterization scheme.

      Again, for purposes of this article, enterprises will be considered to be technology-based when they are using or adopting technologies that have the following characteristics:

      1. technologies that represent an effort to improve productivity or efficiency, reducing cost and resource constraints by relying on tools, practices, and recently introduced materials and resources --usually with the anticipation of reducing human resource requirements (in terms of numbers of workers and/or skill levels required);

      2. aggressive technologies that are being adopted in anticipation of near-term competitive pressures, or that open new opportunities for commercial exploitation; and

      3. technologies that represent a substantive evolutionary progression from the current base.

      It is probably a good idea to avoid using terms such as "high-tech, "cutting edge," or "breakthrough," since they have been so overused and misused that they have become meaningless. To complicate matters further, there is no well-organized or generally accepted system for categorizing or characterizing technology change. However, it is clear that change is the norm, and what is considered "technology" today may soon become either commonplace (e.g., photocopy machines) or largely obsolete (e.g., typewriters).

   2. Conventional Due Diligence

      From a legal standpoint, due diligence is commonly understood as a defense against securities fraud claims predicated on false or misleading disclosure documents prepared in connection with the public sale of securities. (13) Section 11(a) of the Securities Act of 1933 (14) subjects a relatively broad class of persons to potential liability for material misstatements or omissions contained in a registration statement (including the prospectus, which must be filed as part of the statement). (15) Section 11(b)(3) (16) contains the due diligence defense, (17) which basically exonerates any defendant, other than the issuer, (18) who can show, after reasonable investigation, that he or she had reason to believe and did believe, that there was no material misstatement or omission in the registration statement. (19) The due diligence defense requires defendants to prove that they exercised reasonable care in investigating the accuracy of the issuer's disclosures, with such reasonableness as would be expected from "a prudent man in the management of his own property." (20)

      Although not recent, Escott v. BarChris Construction Corporation (21) remains the leading case on the issue of what constitutes an appropriate investigation. (22) While BarChris adopted a sliding scale for judging the reasonableness of due diligence investigations, the case makes it clear that, at a minimum, affirmative action must be taken to independently verify information in the registration statement. (23)

      The legal conceptualization of due diligence is, of course, a limited one. "Due diligence" can mean more than a potential affirmative defense for those having a connection with a materially false or misleading registration statement. For example, due diligence has a role in protecting the interests of both the investor and the issuer in private placements as well as public offerings. (24)

      Conventional due diligence is, however, an in-depth analysis of the financial and operational conditions of a company targeted for investment, merger, or acquisition. It may be as detailed as an accounting audit, since the operational condition and efficiency of the target's assets are also investigated. (25) Due diligence is generally designed to ascertain the economic values...