Navigating M&A due diligence in Australia’s technology sector

The technology sector in Australia is a vibrant and competitive market, where mergers and acquisitions (M&A) are crucial for growth and market expansion. 

However, the technology industry can be an M&A minefield. To ensure your investment is successful and profitable, due diligence is a must.

In this article, we will explore some of the critical areas of due diligence that buyers need to consider when acquiring technology companies.

Increased mergers and acquisitions in Australia's tech sector

Data from S&P Global Market Intelligence shows a sharp increase in M&A activities within Australia’s information technology sector. In fact, they have recorded more than 700 transactions since 2020. Most of these transactions occurred within the Software and Services subsector, which is driven by innovation, digital transformation and lower technology costs. These factors make the information technology sector an attractive and lucrative sector for M&A. Naturally, the attractiveness of this sector draws the interest of a broad range of buyers. These can include corporations, private equities, family trusts, etc.

Although the sector shines with the promise of potential, buyers should proceed with caution. This sector is wrought with complex challenges and inherent risks to navigate. Due diligence, performed by someone with industry experience, should be a key component of this growth strategy.

Foundations of due diligence in the technology sector

When evaluating the acquisition of technology companies, several critical due diligence areas demand special attention. First and foremost, understanding the technology and intellectual property owned by the target company is essential, as it forms the foundation of its value. Additionally, assessing the financial health and stability of the company, including its revenue streams, profitability, and potential liabilities, is crucial for making an informed decision.

Each of these elements significantly influences the success and outcome of transactions.

Revenue recognition in the technology sector is complex

Revenue reporting in the technology industry can be complex, as many contracts involve multiple products or services that are delivered at different times or have different prices.

AASB 15, issued by the Australian Accounting Standards Board, sets the rules for how Australian businesses (including those in the technology sector) should report their revenue. This standard primarily focuses on revenue arising from contracts with customers, aligning its principles with the International Financial Reporting Standards (IFRS) framework. AASB 15 helps businesses to identify the separate performance obligations in each contract, determine the fair value of each obligation, and recognise revenue when each obligation is fulfilled.

When examining contracts in the technology sector, these concepts can be hard to understand and equally difficult to apply. Whilst the accounting standard governs revenue recognition and thus affects EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), it does not necessarily affect the timing of cash flows. The inter-relationship between EBITDA and cash flows is another crucial area that every investor should gain an understanding of.

Deferred revenue – debt or working capital?

One of the most common negotiation points for any acquisition in this sector is how to handle deferred revenue in the sales and purchase agreement. Deferred revenue is generally defined as money that customers pay before they receive the services. This can become complicated as many transactions are structured on a cash-free, debt-free basis. That means buyers should consider the cash requirements to continue providing that service once the deal is complete.

There are ways to recuperate such costs, such as treating deferred revenue or cost to service as debt. An investor 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.

Value drivers of a SaaS company

In the technology sector, many companies sell their products as Software-as-a-Service (SaaS) where customers pay for regularly as a subscription. The valuation for a SaaS business is often linked to its Annual Recurring Revenue (ARR) or Monthly Recurring Revenue (MRR).

However, it is important to understand the dynamics of the business recurring revenue stream and what affects it. For instance, revenue will be impacted by a combination of factors such as customers leaving (churn), buying more (upsell) or less (downsell). Customer retention can be measured in different ways and some ways can be misleading if everything is not included (for example not counting downsell or using upsell to hide customer attrition). Investors need to understand what these metrics mean and how different terminology could impact valuation.

Taxation due diligence should include relevant R&D tax incentives

Tax compliance due diligence is standard for any transaction, however there are special considerations for M&A in the tech sector. Of particular note in Australia is the Research & Development (R&D) Tax Incentive. This government initiative provides funding for businesses who allocate resources to research and development.

However, there are strict eligibility criteria for claiming this incentive. Companies who make inappropriate claims may face clawback from the Australian Taxation Office.

The incentives are provided to businesses either through a refundable or a non-refundable tax offset. The amount given is determined by an aggregated turnover threshold. Whilst the definition of aggregated turnover is technically complex, it can generally be defined as the total money made by the business and its related businesses. So, when a company buys another company, it is important to assess howthis will affect their aggregated turnover and eligibility for R&D Tax Incentive.

IT due diligence means reviewing software code and IT security protocols

IT due diligence has become a common component of the modern acquisition landscape, to help investors understand the assets and associated risks. This will include a comprehensive review of the software product code and cyber security controls. This targeted review provides insight into the structural framework and architecture of a target company's software code as well as their custom software development procedures and processes. This review should provide clarity around:

• Whether the target company has sufficient controls in place to protect data privacy and IT security.
• The existing software product roadmap. 
• The scalability of the IT infrastructure to support the software product for future growth.

For acquisitions within the technology sector, IT security and privacy are a key priority. Data breaches, regulatory non-compliance and inadequate control environments can significantly impact a business's integrity and reputation. Before investing, it is important to evaluate these risks and assess how much it would cost to correct any issues.. This preventive measure will help  avoid unexpected challenges and fortify the  investment strategy.

Sell side due diligence

Sell side due diligence is an important process when selling a business. It helps to make the sale process more consistent and transparent. Sellers use sell-side due diligence to find and fix any hidden concerns, such as software revenue recognition issues, before they engage with  potential buyers. This lowers the chance of the deal falling apart. We expect this trend to grow due to the clear value in facilitating smoother transactions and reducing potential obstacles.

Phased due diligence for complex transactions

When buying or selling a business, both parties want to identify potential issues as early as possible. Within the current M&A landscape, that has translated to both investors and sellers intensifying their due diligence efforts. A common way to do this is to split the due diligence into phases, starting with key areas such as revenue recognition (including deferred revenue) and customer retention. If these are satisfactory, then the next phase looks at quality of earnings and analysis of working capital. This phased approach can be flexible and cover other areas of due diligence, depending on the type of deal. This phased approach to due diligence helps to deal with complex transactions more effectively.

Key takeaways for navigating M&A due diligence in the information technology sector

In summary, navigating M&A due diligence in the realm of information technology sector can be a complex and daunting process. However, with careful planning and execution, it can lead to successful mergers and acquisitions that benefit both parties . Embracing the due diligence considerations highlighted above ensures informed decisions, lowers risks, and propels sustained growth for the Australian technology sector.

By seeking the guidance of experienced professionals and utilising comprehensive checklists and frameworks, organisations can ensure a smooth and successful due diligence process. Ultimately, the key to a successful M&A transaction is transparency, communication and a shared understanding of goals and objectives.

FOR MORE INFORMATION

If you need help with due diligence to support an acquisition in the technology sector, reach out to one of our Corporate Finance specialists.