In the frantic lead-up to an exit, I often see founders and their bankers waving a SOC 2 Type I report like a golden ticket. They treat it as proof of enterprise maturity, a badge that says, "We are secure."
As an Operating Partner, you know better. And if you don't, your Investment Committee certainly does.
The distinction between Type I and Type II is not just semantic; it is the difference between intent and execution. A SOC 2 Type I audit evaluates the design of a company's controls at a specific point in time. It confirms that, on paper, the company has written policies for password complexity, data backups, and employee offboarding. It effectively asks: "Did you buy the lock?"
A SOC 2 Type II audit evaluates the operating effectiveness of those controls over a period of time, typically 6 to 12 months. It requires evidence that the backup actually ran every night, that the terminated employee was actually removed from Slack within 24 hours, and that the firewall logs were actually reviewed. It asks: "Did you actually lock the door every night for the last year?"
Founders prefer Type I for obvious reasons: it is faster and cheaper. A motivated CTO can rush a Type I audit in 4-6 weeks with a compliance automation platform and a friendly auditor. It costs $15k-$25k and checks the immediate box for early-stage customer procurement teams.
But for a Private Equity buyer, a Type I report is a red flag disguised as an asset. It suggests the company has no track record of operational discipline. It screams, "We just built these processes yesterday to sell the company."
When we see a Type I report in the data room without a corresponding Type II roadmap, we don't see security; we see Operational Debt. We see a management team that hasn't yet proven they can maintain governance when no one is watching.
The absence of a SOC 2 Type II report doesn't just annoy your CISO; it directly impacts the financial mechanics of the deal. The consequences manifest in two specific areas: Reps & Warranties Insurance (RWI) and Revenue Quality.
Reps and Warranties insurers are no longer passive observers of cyber risk. With the average cost of a data breach now hitting $4.88 million, underwriters are tightening their grip. While a SOC 2 report isn't explicitly mandated by every policy, the absence of demonstrated controls (which SOC 2 Type II provides) frequently triggers a "Cyber Exclusion" or a massively inflated retention (deductible) for cyber breaches.
If your target cannot prove operational security effectiveness (Type II), the insurer may refuse to cover the "Sufficiency of IT Systems" representation. This forces the buyer to self-insure that risk, often leading to a specific indemnity escrow (typically 5-10% of deal value) held back from the seller. That is real cash off the table at closing.
Your diligence isn't just about whether the company gets hacked; it's about whether they can keep their revenue. Market data indicates that 66% of B2B buyers now demand SOC 2 reports as a condition of purchase.
If your portfolio company is selling to the Enterprise (Fortune 1000), a Type I report is a "conditional pass" at best. Enterprise procurement teams will often sign a contract with a Type I but include a Post-Closing Covenant requiring Type II attestation within 12 months.
If the portfolio company fails that subsequent audit—which is common for firms that "crammed" for the Type I—they breach the contract. I have seen multi-million dollar ARR contracts terminated for cause because a portfolio company failed to deliver their Type II report on time. That is not a technical failure; that is revenue leakage.
So, do you force every portfolio company to get SOC 2 Type II immediately? Not necessarily. It depends on your hold period and exit horizon. Here is the decision matrix for the Operating Partner.
If you are more than a year from exit, Type II is mandatory. The ROI is clear: it smooths enterprise sales cycles and removes a major friction point during the eventual sale process. Start the observation period now. Modern compliance automation tools (Drata, Vanta, Secureframe) have reduced the manual lift by 60-70%, making this a defensible EBITDA impact.
Do not let the CTO delay this. A "clean" Type II report requires a 6-12 month observation window. If you wait until you hire an investment bank, it is already too late.
If you just acquired a messy asset or are prepping a distressed sale in under 6 months, you do not have time for Type II. In this case, execute a Type I + Bridge Letter strategy.
For a PE buyer, SOC 2 Type II is the only metric that matters. Type I is a marketing brochure; Type II is a background check.
If you are buying, discount the valuation of any firm that only has Type I, citing the "integration cost" of bringing them up to standard. If you are selling, understand that your Type I report is not an asset—it is merely an I.O.U. that the buyer will have to cash.
Do not sell security debt. Sell a system that works.
