Because annual recurring revenue (“ARR”) growth, revenue retention, and cash flow metrics are key drivers of software company valuations, investors need to fully understand and validate these metrics before closing a transaction.
ARR validation
ARR by customer by product is often tracked by the investment target’s (the “Target’s”) management team via an internal CRM or via an external Excel spreadsheet, which often does not reconcile to their general ledger. Before a letter of intent is signed, the Target’s internal ARR schedule is typically shared with prospective investors and bids are largely based on that number.
ML&R rebuilds and validates ARR by spreading all invoice line items reflected in the general ledger over the applicable service periods. As a result, our clients can rest assured that actual customer invoices support the ARR calculation. In addition, all credit memos and discounts are included in ML&R’s invoice spread analysis, as they are often the driver that bridges “ARR per CRM” versus “ARR per ML&R’s analysis”. Finally, ML&R discusses potential churn and downsells with the management team and analyzes past due accounts receivable to identify potential ARR at risk of churn.
ML&R’s recalculation of ARR at the invoice and credit memo line-item detail level allows us to then easily cut ARR retention by any dimension (by customer, by product, by cohort, etc.) to identify key insights into the Target’s revenue cube.
Further, ML&R’s recalculation of deferred revenue by month via the invoice spread ensures accurate net working capital and indebtedness calculations at closing and for the opening balance sheet.
Cash flow validation
To analyze the Target’s cash flow generation, ML&R performs a proof of billings which compares revenue plus change in deferred (and accrued) revenue to the invoices and credit memos included in our ARR validation dataset. Through this analysis, ML&R validates the accuracy of the Target’s monthly deferred revenue calculation and also measures the incremental cash flow generation from billing in advance.
To recap, it is our view that an independent ARR invoice spread and proof of billings analysis is critical to:
- Validating true ARR after discounts and credit memos;
- Validating deferred and accrued revenue balances for the calculation of net working capital and indebtedness; and
- Measuring the incremental cash flow from billing in advance of service periods.
Not all QoE providers perform these critical analyses. ML&R strongly believes that while performing the ARR invoice spread and proof of billings analysis takes additional time during an engagement, the benefit of validating ARR, deferred revenue, and accrued revenue greatly outweighs the incremental time and cost. Understanding true ARR and cash flow on the front end is key to avoiding unpleasant post-transaction surprises.
