Due diligence is a key part of any procurement process.sale of companies. Its purpose is to validate all the information that has been provided to the buyer. Each sector has its peculiarities and the IT sector is no exception. Here are 10 observations made by McGaldrey, an expert in DD services in the ICT sector. Last year it carried out 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 performing more due diligence and identifying major issues early. We are frequently asked, to phase our diligence, to first address the areas of revenue recognition (deferred revenue) and sometimes capitalisation of software development. If these issues 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 recognised 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 recognise configuration revenue over the length of the contract term and the estimated length of customer relationships, this may mean that instead of recognising configuration revenue in the first month or two of a contract, it could be recognised 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 in order to focus on the most common risk areas.
6. Deferred "haircut" income:
The concept that deferred revenue may fade or receive a significant haircut as a result of the transaction is difficult to understand. Generally, deferred revenue in the closing balance sheet of the oldco jumps off a cliff with the accounting application of US GAAP purchases in the opening balance sheet of the newco. For accounting purposes, deferred maintenance, subscriptions or implementation revenues are reduced to the cost of providing the service, plus a reasonable margin. The buyer must understand this concept and apply it in modelling future revenues and earnings, as well as the structure of the loan covenant (if the transaction is leveraged).
7. Capitalised software development costs:
Investors want to know what the company's EBITDA looks like with and without the capitalisation of software development costs. A common misconception is that management teams sometimes fail to recognise that the accounting treatment representing capitalisation of software development is typically different for software companies and SaaS companies.
8. Working capital or an effective exchange rate for labour:
The idea of stagnant working capital seems old hat today, but it is highly nuanced in the ICT industry, due to the treatment of deferred revenue, where the focus is on its life cycle and seasonal accounting. If deferred revenue has historically not been recorded in accordance with US GAAP, designing or establishing working capital and its subsequent resolution 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, sellers are increasingly including sell-side due diligence as part of the process. Sell-side due diligence helps uncover unknown issues that buyers are involved in (e.g., recognition of software revenue), supports or enhances the value of the seller's proposal, and helps decrease the risk of a deal breaker.
10. Taxes really matter:
The tax ramifications on financial diligence and quality of earnings 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 cannot 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.
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