Improving the M&A process and transaction performance
How corporate M&A teams are leveraging code diligence
M&A GUIDE
Foundations for Corporate M&A Professionals
Executing Code Diligence
Software code diligence is becoming standard practice for many corporate acquirers.
The primary goal is to assess the target’s technology assets to identify risks, liabilities, and post-close opportunities.
Most importantly, code diligence quantifies the target's 'technical debt,' allowing buyers to plan for integration and potentially deduct remediation expenses directly from the purchase price.
Code diligence reports typically provide insights into:
- Quality of the codebase and scalability potential
- Use of various licenses and open source code
- Health of the technology infrastructure
- Critical cyber security risks
Open Source and IP Risks
Code reviews scrutinize open-source and third-party components to verify license compliance, preempt IP claims, and ensure a clean title can be transferred post-close.
The deal parties will generally negotiate read-only access to the source code repositories (e.g., GitHub, GitLab, AWS CodeCommit, Google Cloud, etc.) to conduct a Software Composition Analysis that identifies every open-source library and its associated license.
A key concern is that an acquisition will shine a spotlight on the seller and attract IP claims against the new owner, which is often a more attractive litigation target.
At the annual M&A Conference San Francisco, a poll of corporate M&A teams found IP and open source risks were the primary trigger for code diligence, however, additional benefits were identified.
Cyber Security Concerns
Corporate M&A professionals also pointed to the value of code diligence for identifying potential security flaws, cyber-breach vulnerabilities, and general weaknesses in the codebase.
To extend the code review, Static Application Security Testing (SAST) is done to analysis proprietary code for structural quality, security flaws, and hardcoded secrets.
In some transactions diligence extends to the target's hardware, network and cloud infrastructure, data storage, recovery, privacy compliance (e.g., GDPR, CCPA), and data governance policies.
Increasingly AI-enhanced code reviews are giving M&A teams the efficiency and scale they need to meet compressed deal timelines.
The move beyond manual code diligence is deepening the analysis by instantly flagging syntax errors, style violations, pattern-based security vulnerabilities, and performance bottlenecks.
Code Diligence: Red Flag Reports
A comprehensive code diligence report translates technical debt into a thesis-driven financial assessment, estimating the exact time and costs required for remediation.
This financial analysis can then be used by the M&A team to adjust the purchase price, demand pre-close remediation, or set up escrow holdbacks.
Corporate development teams should coordinate with the legal and engineering teams to align liability caps, financial thresholds (baskets and deductibles), and materiality qualifiers in the purchase agreement.
They should also coordinate with the M&A Integration team to evaluate:
- Integration Friction: Assess tech stack compatibility; identify legacy frameworks, obsolete languages, or incompatible databases needing costly immediate rebuilds.
- Key-Person Dependency: Examine commit history for critical infrastructure reliance on few developers, flagging operational risks if they exit post-close.
- Viral License Exposure: Detect "copyleft" open-source licenses that could legally mandate exposing the acquirer's proprietary source code.
- Scalability Roadblocks: Evaluate if current architecture supports growth projections or requires significant capital expenditure to prevent failures at scale.
- Third-Party Vendor Reliance: Map external API and vendor dependencies to identify potential supply chain, data privacy, and margin risks.
Engineering Talent Retention
Although most deal teams aim to assess the target’s talent and skill-sets during diligence, a poll during the annual M&A Conference San Francisco found just 10% of the participating deal teams shared code diligence findings with the M&A HR team.
This finding suggests more could be done to leverage code diligence to identify critical talent and tailor the retention strategy.
In fact, some of the most effective M&A teams are using code reviews to put additional retention funds against developers that produced high-volume and quality code.
These assessments are also helping the M&A integration team determine whether to maintain the target’s software development lifecycle methodologies, development tools, and technologies post-close.
Timelines for Code Diligence
Negotiations with the seller should allow sufficient time to review the target's code, IP portfolio, relevant agreements, and legal history.
A high-level review can generally be done in 1-2 weeks, while a standard review takes 2-4 weeks.
A more thorough analysis, including performance testing, detailed security assessments, scalability analysis, and a comprehensive IP review can take 4-8 weeks.
Factors influencing the timeline include:
- Size and complexity of the codebase and technical architecture
- Scope of the review and expertise of the diligence team
- Quality of documentation, readability, and overall software design
- Availability and responsiveness of the target company's team
Exclusively for Members of the Transaction Advisors Institute
Advanced Playbooks, Templates, and Negotiation Frameworks
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FAQ on Code Diligence
Several deal points can be incorporated into the acquisition agreement including representations and warranties that the seller has clear and unencumbered ownership of all IP rights, including copyright, patents (if any), and trade secrets -- and that the code does not infringe upon the IP rights of any third party.
It’s also important to ensure the acquisition agreement is clear on representations as to the use of open-source software and warranties that the target company has complied with all applicable open-source licenses to head off restrictions associated with such licenses.
Increasingly, public company M&A teams, like private equity, are obtaining representations and warranties insurance (RWI) to provide coverage for breaches related to IP in the code. This can offer an additional layer of protection that is easier to pursue than a claim upon the seller.
If any issues do arise, the buyer will want to have insisted upon comprehensive indemnification clauses to protect against any losses, damages, liabilities, costs, and expenses (including legal fees) arising from any breach of the IP-related representations and warranties.
Having an internal engineering team evaluate the target’s code for scalability and proper protocols has been recommended by the members of the Institute.
To get the best view of post-close integration challenges and opportunities, it can be helpful to apply internal ratings to assess the target’s engineering team against the company’s specific standards (i.e., asking ‘How would we measure them if they build code here?’).
To execute an effective peer-to-peer review, it has been suggested that corporate development should stay out of the room, and only interface with the product teams, rather than directly with engineering.
The Institute’s members have found ‘engineering-to-engineering’ discussions revealed far more meaningful insights.
Having corporate development in the room stifled the exchange and often shifted the focus to deal topics (i.e., the economic and legal aspects of the transaction).