Will simply restoring IT budgets to pre-pandemic levels really help stressed tech teams to support remote work, modernize customer experiences and mitigate cyber threats? That’s unlikely—especially at companies with high levels of technical debt.

Originally coined for software code gaps, technical debt now commonly refers to all technology modernization, update and repair needs. Tech debt’s a growing problem. McKinsey recently surveyed CIOs at fifty financial-services and technology firms with revenues in excess of $1 billion. Sixty percent responded that tech debt had “risen perceptibly” at their companies over the past three years.

Even more concerning, IT budgets aren’t keeping pace. Ninety-two percent of the CIOs McKinsey surveyed reported using less than a fifth of current IT budgets to reduce tech debt. To cover shortfalls, nearly 70% of tech leaders steered over 10% of new project money to fix infrastructure—and some even used over half those funds.

As much as McKinsey’s survey results are eye-opening, its solution is lacking. McKinsey characterizes reallocating current and future IT spending towards modernization as tech debt’s “principal” and “interest” payments. That’s exactly the flawed logic that confuses CFOs and balloons tech debt.

Better perspective

While typical fixed asset borrowing is repaid with interest over time, tech debt grows silently “off the books” without any requirements. That’s a big reason why boards overlook technical debt and miss its far-reaching business implications.

To change that, here’s a novel budgeting question for CIOs to ask: What tech and financial due diligence would a potential merger partner or acquirer perform? The answer recasts IT needs in terms of two valuation tests that M&A specialists conduct regularly—asset impairment and contingent liability estimation.

Wayne Sadin, a board advisor to investment and consulting firm Via Group Partners who has over three decades of CIO and CTO experience, agrees. “Directors are always concerned about company valuation. M&A techniques offer a great way to improve boards’ understanding of tech debt,” said Sadin. “Astute acquirers have strong incentives to look beyond what’s on the books to uncover what may be lurking off-balance-sheet.”

“When buying a production facility, due diligence specialists send competent engineers to identify what it takes to bring the plant up to code and company standards,” Sadin added. “If a company is looking to acquire another business, a key question is: ‘What’s the cost of the delta between an acquiree’s current capabilities and what it needs to run well?’ That approach applies to tech also.”

Keep it simple

To quantify tech debt, IT’s “upgrade, replace or retire” timetable is an ideal place to start. It likely identifies all existing or desired technology which needs funding.

Underfunded technology investments are similar to impaired assets, such as poorly performing subsidiaries, expiring patents or obsolete factories. Aging servers, noncompliant software and nonsecure user devices likewise impede customer experience and employee effectiveness. Once impaired assets are identified, companies can choose to fix, replace, write down or abandon them.

Unfunded technology initiatives are comparable to contingent liabilities, such as litigation payments, environmental remediation and warranty claims. Costly unaddressed tech issues result in uninsured cyber breaches, service failures and operational downtime. When such obligations are both likely and measurable, companies record liabilities, fund cash reserves and prepare detailed disclosures.

Due diligence tech debt accounting is straightforward—it’s the sum of asset impairments and contingent liabilities. But Sadin cautions CIOs and CFOs not to complicate the math with endless debates about estimates. “CIOs can [give] a rough order of magnitude estimate on tech debt,” he argued. “What’s far more important is explaining why outdated mainframe assembler code that requires countless undocumented patches hampers strategic, operating and financial goals. That’s exactly what an acquirer’s due diligence valuation techniques aim to accomplish.”

Real risks

It’s quite possible that due diligence will uncover high technical debt. CIOs should welcome that revelation. Once tech debt is measurable, understandable and actionable, the odds of reducing it improve dramatically. That’s because a due diligence approach shifts the central tech funding question from “how much money?” to “can we strategically afford the consequences of not investing?”

Sadin cites the recent near system-wide collapse of the Texas power grid. “The Electric Reliability Council of Texas (ERCOT) was just a few minutes away from having to restart the entire state grid—which never has been done before,” he noted. “That’s a terrifying example of tech debt that could have taken many human lives and severely damaged hard-to-repair electricity generation plants.” Energy experts suggested that timely investments in artificial intelligence and contemporary technology could have prevented the shutdown’s worst effects.

Tech debt can also slow or prevent business growth. Sadin recalled a manufacturing client that “wanted to sell direct-to-consumer, but their initiative never launched because an old back-end ERP system wasn’t built to anticipate online order fulfillment data needs. Their ERP team declared that the system update would take three years. By then, the market opportunity was long gone.”  

Whether to avoid downtime or gain market share, boards need to prioritize tackling tech debt. “Directors must be cognizant of the technology that underpins everything their companies either do or want to do,” Sadin advises. “As a first step, M&A valuation techniques can be used to clearly and effectively quantify tech debt. They can also help CIOs better explain why reducing tech debt is so critical to company competitiveness, business agility, profits and cash flow.”

Solving the puzzle

The real cost of technical debt is competitive disadvantage. No company wants to chase rivals, lose customers, frustrate suppliers or battle regulators. To thrive in the post-pandemic economy, CIOs and CFOs need to solve the tech debt puzzle.

In its report, McKinsey concluded on an upbeat note. “The good news is that tech debt can be measured and managed. With the right approach, organizations can regain control and refocus their technology resources on creating value for customers and the business.”

That’s all true and quite intuitive, but the critical question is: what approach is in fact the right one? Due diligence techniques will yield much better answers than vague and tepid consultant-speak.