MLR

Top 5 Deal-Breakers in Financial Due Diligence for Software Company Targets

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By Brandon Lamb, J.D., CPA, Due Diligence Partner and Evan Morris, CPA, Due Diligence Associate

Maxwell Locke & Ritter’s Transaction Services Team specializes in providing financial due diligence (quality of earnings) assessments to clients considering investments in software and tech-enabled services. The 5 most common issues we uncover during our engagements, and our strategies to address and correct them, are outlined below:

1. Poor Recurring Revenue Growth
    • Private equity investors pay a premium for reliable, recurring (subscription-based) revenue streams. If the target company has difficulty growing that revenue base, or if growth is stagnant, the ability of the investor to scale the business post-transaction as expected may prove to be unrealistic.
    • In an effort to inflate a company’s valuation, Sellers may incorrectly classify non-recurring revenue streams (e.g., professional services or upfront setup fees) as recurring. Our due diligence procedures are focused on understanding the quality of the recurring revenue base and ensuring the Seller’s revenue classifications are correct.
2. Unfavorable Customer Retention Trends
    • A software company’s ability to retain its customer base (i.e., the “stickiness” of its products) is an important factor in valuing that business. Acceptable revenue retention rates vary by industry sector, end user type, and annual contract value (ACV).
    • The effectiveness of the target’s sales and marketing function and historical customer acquisition costs (CAC) should also be evaluated when assessing retention. If it is found to be difficult and costly to add to the recurring revenue base, an investor’s evaluation of the target’s revenue retention rate should be adjusted accordingly.
3. Inaccurate Reported Gross Margin
    • Subscription-based software companies should generate significant gross margins. Above-average gross margins allow subscription-based businesses to scale quickly. This, in turn, drives enterprise value.
    • Our diligence procedures analyze the true cost to deliver services and are focused on identifying and reclassifying expenses inappropriately classified below the gross margin line. In general, items classified in cost of sales should include all expenses incurred to maintain and serve the current customer base.
4. Poor Accounting Systems and Procedures
    • Generally Accepted Accounting Principles (GAAP) in the United States requires software companies to recognize subscription-based revenue evenly over the contracted term. Rudimentary accounting and reporting systems and/or lack of dedicated accounting personnel may make it difficult to validate recurring revenue levels and raises concerns over the company’s ability to generate reliable, accurate financial statements post-transaction.
    • In addition to validating historical monthly recurring revenue using our internally developed model, our diligence procedures include making qualitative observations of the target’s accounting information systems, accounting personnel, and internal controls over financial reporting.
5. Sales Tax
    • Evolving sales tax guidelines are complex for any business, but for software companies selling products and services to customers in multiple jurisdictions, those guidelines are especially complex.
    • Each state determines what types of software or information services are taxable. The 2018 United States Supreme Court decision South Dakota v. Wayfair further complicated matters by stating nexus could be established via economic presence only (no physical presence required).
    • Our due diligence procedures estimate the potential historical sales tax exposure by state for software targets that have failed to collect and remit sales tax in states that tax cloud-based or downloaded software.

By focusing on these key potential deal-breakers, our Transaction Services Team aims to provide valuable insight into a target’s operations and ensure our clients make informed investment decisions.

 

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