If there’s one thing that CIOs have to understand when selecting a software vendor, it’s this: The software industry is fundamentally unstable.

Every year there’s a hot new trend in IT. Whether it’s ERP, e-business, CRM or wireless, vendors flood the market, hoping to make a killing off of a CIO’s need to stay competitive. But the intense competition inevitably leads to a shakeout. The weaker companies’ earnings start to slip, and in time they declare bankruptcy or are acquired by a larger competitor. Such was the case with Chicago-based System Software Associates (SSA), which left at least one ERP customer floundering when it declared bankruptcy in April 2000.

Even industry leaders are not immune to financial trouble. After all, they’re under even more pressure from Wall Street to meet earnings expectations, and this pressure sometimes leads companies to cook the books. Belgian speech recognition and translation technologies company Lernout & Hauspie (L&H), for example, made its revenues look better than they actually were, by recording sales before contracts were signed. This alleged financial fraud spurred an investigation by the Securities and Exchange Commission (SEC), which led to L&H filing for bankruptcy. The company’s founders and its CEO have since been arrested and jailed, charged with stock manipulation and falsifying documents.

CIOs, of course, can’t prevent vendors from digging their own graves. But if they are interested in protecting their companies and careers from vendors that go bust, they must learn to do a more thorough job of investigating before signing on the dotted line. Conducting solid due diligence and knowing whether vendors are financially stable is especially important now during an economic downturn, when many companies are going out of business.

Due diligence means taking the time to conduct background checks on the vendor and its management team, and thoroughly investigating its financial position. (That includes examining not just its yearly revenues but determining whether those numbers come from actual sales or from contracts that have yet to be signed.) It means searching for early warning signs that a company is in financial distress, such as the resignation of the chief executive, massive layoffs and restructuring announcements. It means meeting with a vendor’s customers and talking to other software companies that may have been called in to clean up your prospective vendor’s mess. And finally it means doing an RFP to get competitive bids and clarify why you are investing in a certain technology.