Due Diligence (DD) is the examination and evaluation of the target company (Target) in a company acquisition, considering the financial, legal, tax, and economic current state. In addition to the ‘classic’ due diligence by the potential buyer, in recent years, sellers have increasingly been conducting so-called Vendor Due Diligences before starting the sales process to identify and eliminate deal breakers early on. In most cases, external consultants with specialized expertise create an opportunity and risk assessment of the target company based on documents provided by the seller. The potential buyer can thus prepare for contract negotiations based on an objective assessment. The results of the Due Diligence influence the purchase price, the warranty catalog, the Post Merger Integration (PMI), and in some scenarios even the later exit.

External IT Due Diligence for Plannable IT Project and Operating Costs in Carve-Outs

With a targeted focus on the M&A area, we conduct IT Due Diligences for our Private Equity clients and subsequently develop a comprehensive solution for the IT Carve-Out as well as the future IT operations as a stand-alone company or platform acquisition. First, the current state of the target’s overall IT situation is assessed to evaluate which hardware and software are needed for stand-alone operations. In coordination with the planned corporate strategy of the new investor, a proposal is prepared detailing which IT services will continue to be provided by the seller after the legal change of ownership (Closing) for the agreed transition phase and recorded in the so-called Transitional Service Agreement (TSA). If the timeframe for the sales process is very short, we create a so-called Red Flag Report that exclusively contains the essential ‘stumbling blocks’.

The technical process from IT Due Diligence through IT Carve-Out to stand-alone operation or, in the case of platform acquisitions, to Carve-In consists of three phases:

• Analysis of the current state: Current Mode of Operation (CMO)
• Definition of the transition state until the end of the TSA period: Intermediate Mode of Operation (IMO)
• Implementation of the target state: Future Mode of Operation (FMO)

The buyer is also provided with a cost outlook for the IMO and FMO phases in the IT Due Diligence. The total costs are divided into investments/one-time costs (Capital Expenditures), such as purchasing new hardware, and operating costs (Operational Expenditures), such as monthly license fees.
The results of the IT Due Diligence flow into the IT Carve-Out project plan to be created if the investor purchases the target. This includes the required separation steps and their risk on a timeline. It also shows relevant dependencies between the project stakeholders as well as the ramp-up of the new IT landscape and the ramp-down of the (TSA) services.
Often, targets are separated from corporations that were adapted to comprehensive process specifications. We therefore offer our clients a fundamental re-design of processes for the FMO to eliminate existing friction losses and generate cost optimizations. The adapted IT can thus form the basis for restructuring projects and a realignment of the target and significantly contribute to the rapid implementation of the strategy change.

Phase 1: Current Mode of Operation (CMO)

Since it is still open at the time of the IT Due Diligence request by the investor whether they actually want to buy the target, the examination is initially limited to documents that the seller provides in a virtual data room. In addition to IT-specific documents, information about IT is often found in headcount lists, in asset accounting, in financial and investment calculations, in production and shared services descriptions, as well as in supplier documents. This initial analysis of IT is then discussed with the investor, and the open questions are clarified in a Q&A session with the CIO / CTO from the target company. Here, the findings are validated and adjusted if necessary.
For a successful IT Due Diligence, three essential aspects are listed here, among others, which apply to a variety of project scenarios:

• Adapting cost planning to the new corporate structure: The documents provided in the data room often contain financial calculations based on group prices. When separating the target from the group, volume discounts and kickbacks for licenses and IT operations may no longer be available in the future. Investments that have been postponed for years can significantly increase capital requirements in the short term and must be identified early. Additionally, it must be checked whether maintenance and warranty contracts with software and hardware manufacturers are transferred to the target or need to be renegotiated. Caution is advised with in-house developments that may remain with the seller and for which alternatives must be found.
• Streamlining processes and IT architecture for the FMO: The separation of a business unit from a group offers the opportunity to make processes leaner and more effective. The new stand-alone company can redefine workflows and eliminate legacy issues. The same applies to IT – unused software and hardware is eliminated, and the architecture is adapted to the current company situation and strategy. This often results in significant cost reductions in operational business.
• Implementation of the investor’s goal in IT: For IT to integrate seamlessly into the investment case alongside the Financial, Legal, and Tax workstreams, it is important to know the transaction structure, buyer strategy, and investment horizon precisely. Is it a share or asset deal? How will the number of employees change? Is the target a short-term or long-term investment?

At signing, the buyer and seller sign the purchase agreement (Sales and Purchase Agreement) for the target. With the transfer of assets (Closing), the next phase begins for IT – unless pre-closing activities are planned, such as preliminary migrations.

Approach during the Due Diligence process

Phase 2: Intermediate Mode of Operation (IMO)

Based on the findings of the IT Due Diligence, we develop a proposal for the scope of TSA services, in which the target continues to have access to the seller’s IT systems. This transition phase is usually set at three to twelve months: in exceptional cases, up to 36 months can be agreed for multinational targets with complex Enterprise Resource Planning (ERP) systems. The IT Carve-Out should not cause any interruption to operational business.
Based on the planned management of the target, IT legacy systems are sorted out and the new systems are set up flexibly according to the investor’s ideas. If the existing IT systems are outdated software and hardware that is no longer supported by the manufacturer or unsuitable for the investor’s new corporate strategy, a new overall solution is prepared. The separation of IT systems can be carried out with a big bang, iterative, or hybrid approach, depending on requirements and methodology. If the target is not intended to operate as a stand-alone company but is part of a platform acquisition, we check compatibility with existing portfolio companies and expand the cost outlook and IT business plan to include the merger of IT systems, also known as Post Merger Integration (PMI). Since the buyer incurs monthly costs for both the ramp-up of future IT systems and the TSA service, they have a great interest in keeping the duration of the financial double burden as short as possible.

Phase 3: Future Mode of Operation (FMO)

With the expiration of the TSA phase, the IT separation project also ends, and the newly implemented IT system operates flawlessly and cost-optimized. The scope of IT services can be flexibly adjusted if needed. To achieve this goal, our IT Due Diligence report presents the CMO as precisely as possible and evaluates the associated opportunities and risks of the Carve-Out. It includes the following information:

• Overview of the general transaction structure with a focus on IT
• Summary of the current situation as a starting point for later carve-out planning, e.g., divided into infrastructure, non-ERP, and ERP. If the target is to be subsequently integrated into another company, the carve-in must also be considered.
• Planning of the required effort for IT separation and stand-alone operation
• Assessment of project complexity, especially dependencies of IT systems
• Recommendation for the duration and scope of the TSA
• Cost outlook for investment, operating, TSA, and project costs for CMO and FMO

It is also crucial to include the investor’s motivation and the planned approach for increasing the target’s value in the IT Due Diligence. Should the target be fundamentally restructured, integrated into an existing portfolio company, or grow as quickly as possible under its own power?

digatus as an Experienced Provider for IT Due Diligences

In summary, an IT Due Diligence provides valuable insights for the purchase decision, price negotiation, and Post Merger Integration. In the shortest possible time, the buyer has a reliable statement about the current IT health status of the target and knows what efforts and costs are associated with the IT Carve-Out. The IT Due Diligence adapts to the transaction structure of the deal and offers a technical and economic examination of IT. The recommendations for IMO and FMO are based on the investor’s strategy with the goal of process optimization and cost savings.