11 key due diligence considerations for the technology industry
Areas of focus when buying or selling a technology company
INSIGHT ARTICLE |
Technology businesses face an unrelenting demand for innovation, which, in turn, places tremendous strain on existing resources. Likewise, the ever-present need for profitable expansion, frequently through mergers and acquisitions (M&A), domestically and abroad, remains constant. But M&A can bring challenges and risks, too. It’s important to understand the key due diligence considerations from evolving regulatory needs to key financial considerations. To that end, we’ve compiled some important finance and accounting, taxation, operations and information technology (IT) due diligence concerns that all technology organizations need to consider for a transaction.
- Revenue recognition complexities: Effective in 2019, private companies that contract with customers are required to report revenue under a new revenue recognition standard, ASC 606. While the new standard aims to align revenue recognition across industries and geographies, the complex nature of contracts in the technology industry continues to require a unique focus on revenue recognition. To further complicate matters, implementation of the new standard is likely to cause an apples-to-oranges comparison of financial statements pre- and post-implementation.
Revenue recognition in the technology industry is driven by contracts consisting of multiple deliverables. The concepts can be hard to understand and equally difficult to apply. The easy part of software revenue recognition is that even as the accounting issues affect EBITDA and reported revenues, they do not affect the timing of cash flows.
- Deferred revenue: To indebt or not to indebt: One of the most common negotiation points for any acquisition is how to treat deferred revenue in a purchase agreement. Deferred revenue is generally defined as cash received from customers prior to services being rendered. Because many transactions are structured on a cash-free, debt-free basis, consideration should be given to sales cash collected prior to close that a buyer will be required to service post-close. Solutions exist to recuperate such costs, including treatment of deferred revenue or cost to service deferred revenue as indebtedness. A buyer will typically prefer debt-like treatment while a seller will typically prefer working capital treatment. Having a good understanding of the economics and mechanics of these options is critical to ensure fair treatment of deferred revenue.
- Customer retention: Due to the highly recurring nature of revenue in the technology industry, particularly for SaaS products, the customer retention rate for a business is crucial to a company’s valuation and leverage. Customer retention can be defined in several ways and may be misleading if certain components are not appropriately factored into the calculation (e.g., excluding downsell from customer retention rates or netting upsell against customer attrition rates). It is important to understand the impact of differing definitions as they could affect the purchase price.
- Capitalized software development costs: Investors want to know what a company’s EBITDA looks like with and without capitalized software development costs. One common pitfall is that management teams sometimes fail to recognize that the accounting guidance for the capitalization of software development typically differs for software and SaaS businesses.
- Sell-side due diligence: As the process for the sale of a business becomes more and more standardized, sellers are increasingly including sell-side due diligence as part of the process. Sell-side due diligence can uncover unknown issues before buyers are involved (i.e. software revenue recognition) to support or increase the seller’s value proposition and help decrease the risk of deal breakage. This trend is likely to continue for the value it provides.
- Phased diligence: In today’s competitive mergers and acquisitions environment, buyers (and sellers) are performing more due diligence and identifying the most important issues up front. We are frequently asked to phase our diligence scope to first address the areas of revenue recognition (deferred revenue), customer retention and more. If those areas are satisfactory, then on with the quality of earnings and working capital analysis. This approach can apply to exclusive deals or auction processes.
- Deferred revenue “haircut”: The concept that deferred revenue is adjusted to a “fair value” on the post-close balance sheet, which is often less than the carrying value of deferred revenue on the pre-close balance sheet, can catch a buyer off-guard. This deferred revenue “haircut” not only reduces deferred revenue balances, but also reduces revenue recognized post-close. The buyer should understand this concept while modeling future revenue and earnings, as well as structuring the loan covenants (if the transaction is leveraged).
- Sales taxes‒A new frontier: Historically, software businesses required physical presence in a state to have sales tax nexus. The 2018 U.S. Supreme Court’s decision in South Dakota v. Wayfair set a new precedence for economic nexus that no longer requires physical presence. The Wayfair decision will have a far-reaching impact on technology businesses, as states will be able to assert economic nexus over the industry. Some states already have economic nexus sales tax provisions in place, while many other states will likely begin to enact such provisions in the near future. Sales and income tax nexus is one of the more significant areas of exposure in the diligence process.
- Tax attributes: Quantifying a target’s (or seller’s) tax attributes in a transaction is often something that technology companies may not consider. Research credits and net operating loss carryovers can be a valuable asset but may be limited in a transaction. Oftentimes, companies that have generated tax losses don’t want to spend money for research studies to quantify the amount of tax credits that may be available. In addition, these companies may also have undergone changes in their equity structure over time that could limit the amount of net operating losses and tax credits that are available post-transaction. It is important for both the sellers and buyers to understand what tax attributes exist, and the availability of those attributes subsequent to a transaction.
- Software code review: Today’s buyers are frequently completing IT due diligence, including software product code reviews, as part of their acquisition effort in order to gain a well-rounded understanding of the assets and risks being acquired. A targeted software product code review allows the buyer to understand the software code structure and architecture of a target company’s product, and gain insight into the custom software development procedures and processes. This ensures proper controls are in place, clarifies the software product road map and confirms that the IT infrastructure supporting the software product is scalable for future growth.
- Security and privacy: In no industry is IT security and privacy more important than technology. Data breaches, regulatory non-compliance and insufficient control environments have the ability to cripple a business. Assessing those vulnerabilities and costs to correct them is critical to a successful investment. Performing cybersecurity due diligence in advance of closing a deal can help avoid unnecessary surprises.
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