10 keys to due diligence in the tech sector

Due diligence is a key element in any company purchase and sale process. Its objective is to validate all the information provided to the buyer. Each sector has its peculiarities and the tech sector is no exception. Here are 10 observations made by McGaldrey, an expert in DD services in the technology sector. Last year it performed more than 150 DD of software and hardware companies.

1. Complexities with software revenues:

Software revenue recognition remains the most common and most complex problem in the IT industry. The concepts are very difficult to understand and equally difficult to apply. The easy part of software revenue recognition is that even if it has an impact on EBITDA impact and reported revenue, it does not affect the timing of cash flows.

2. Staged proceedings:

Buyers and sellers are carrying out more due diligence and identifying the most important issues earlier. We are frequently asked to phase our diligence, tackling the areas of revenue recognition (deferred revenue) first and sometimes software development capitalisation. If these topics pass muster, we are then asked to analyse the quality of earnings.

Software or SaaS:

Is the business to sell software or SaaS model services? There is sometimes confusion about this question, especially now that many companies are selling both alternatives. The accounting issues are very different depending on the answer.

4. SaaS installation costs:

It seems natural to think that revenue is recognized when services are delivered to customers. That couldn't be further from the truth when setting up or implementing a SaaS Client. Instead, suspend rational thinking and recognize configuration revenue over the length of the contract term and the estimated time of customer relationships, this may mean that instead of recognizing configuration revenue in the first month or two of a contract, it could be recognized over the next seven years, if the customer is expected to have this period of relationship.

5. What about the hardware?

Considering the level of knowledge, we often encounter surprises when inventory and cost of sales are sometimes incorrectly recorded in hardware companies, as they are often overlooked to focus on the most common risk areas.

6. Deferred income «haircut»:

The concept that deferred revenue can vanish or take a significant haircut as a result of the transaction is difficult to grasp. Generally, deferred revenue on the closing balance sheet of Oldco falls off a cliff with the application of purchase accounting under US GAAP on the opening balance sheet of Newco. To work out the accounting, deferred maintenance, subscriptions or implementation revenue are written down to the cost of rendering the service, plus a reasonable margin. The buyer must understand this concept and apply it in the model for future revenue and earnings, as well as the structure of the loan covenants (if the transaction is leveraged).

7. Capitalised software development costs:

Investors want to know what the company's EBITDA looks like with and without capitalizing software development costs. A common misconception is that management teams sometimes fail to recognize that the accounting treatment representing capitalization of software development is typically different for software companies and SaaS companies.

8. Working capital or an effective working exchange rate:

The idea of stagnant working capital seems old hat today, but it is very nuanced in the technology industry, due to the treatment of deferred revenue, where the focus is on its life cycle and seasonal accounting. If you have historically not recorded deferred revenue in accordance with US GAAP, the design or establishing working capital and subsequent workaround can be very complicated. We work with investors who run the gamut for the treatment of deferred revenue with respect to working capital, from excluding it entirely, to adjusting for the cost of providing future services (see observation. 6), to including the entire lack of adjustment. In the absence of good benchmarks for establishing working capital, sometimes the solution lies in estimating cash instead.

9. Sell-side due diligence:

As the process for selling a business becomes increasingly standardised, vendors are increasingly including sell-side due diligence as part of the process. Sell-side due diligence helps to uncover unknown issues that buyers are concerned with (for example, software revenue recognition), supports or increases the value of the vendor's proposition, and helps to reduce the risk of a deal falling through.

10. Taxes really matter:

The tax ramifications on financial diligence and earnings quality are particularly severe in the software industry. Rules and regulations for sales taxes, which must be included in EBITDA, can vary from state to state or country to country. If a company is unable to recover taxes from customers, the corresponding amounts should be considered a reduction of EBITDA or at least considered a debt similar to an account payable (with interest and penalties) by the vendor at closing.