MLRPC © 2023 All Rights Reserved.
Valuations are often based on a multiple of a company’s annual recurring revenue (ARR), so rebuilding historical ARR using the target’s accounting source data is vital to our confirmatory diligence process. Oftentimes a company’s pre-LOI ARR presentation is based on CRM data (rather than accounting system data), which may result in errors, discrepancies and/or timing differences.
Our analysis of ARR begins with obtaining the most granular invoicing data available and working with the management team to separate recurring revenue streams from non-recurring and re-occurring services (i.e., professional services, implementation, etc.).
Using invoice term data, we allocate revenue across the appropriate service periods and independently build an ARR/deferred revenue waterfall. The ARR rebuild process requires judgment and expertise because invoice term data is often incomplete or incorrect. We reconcile our analysis to the Target’s ARR presentation to ensure any differences can be explained. Differences typically arise due to invoicing delays and billing irregularities, so we ensure our presentation corrects any such anomalies.
After the invoiced ARR rebuild is complete, we obtain any newly signed but un-invoiced contracts and discuss with management any known churn, upsells or downsells to incorporate into our presentation of contracted ARR (CARR).
Gross profit margin is an indicator of a company’s overall financial health and ability to efficiently generate profits. SaaS businesses have the advantage of scaling their costs as they grow their revenue, so high gross margins may also be indicative of its potential investment return.
Bifurcating total gross margin between recurring versus non-recurring gross margin is one of the most important metrics for an investor to carefully measure. Getting it right helps an investor understand key cost drivers, forecast future profitability, and assess operational leverage. However, we often analyze companies that do not allocate (or do not allocate accurately) payroll costs to cost of sales, which results in inflated and inaccurate margins.
The transaction advisory team at Maxwell Locke & Ritter specializes in performing QoE’s on SaaS and other recurring revenue companies throughout the US, Canada and EMEA. We serve private equity groups, lenders, family offices, and corporate entities on both buy-side and sell-side transactions.
