Tech sector due diligence: Key tips

Diligence, in the context of mergers and acquisitions, refers to the thorough investigation and evaluation of a potential investment or business opportunity. When performing due diligence in technology acquisitions, there are specific value drivers unique to the sector. Understanding these drivers is essential, as they can significantly influence the success and viability of an acquisition.

By gaining meaningful insights into these factors, acquirers can make informed decisions, mitigate risks, and ultimately enhance the chances of a successful acquisition.

Key technology sector trading metrics

Annual recurring revenue (‘ARR’) and monthly recurring revenue (‘MRR’)

ARR represents the annual value of the business’ subscriptions or contracts at a specific point in time. ARR is often considered the minimum revenue a business is expected to earn over the next 12 months, assuming no new additional subscriptions are sold, an important consideration for a potential buyer ahead of a transaction.

MRR represents the monthly value of the business’ subscriptions or contracts at a specific point in time. This is often the foundation of an ARR calculation, with ARR being MRR multiplied by 12 months.
Internal reporting of MRR and ARR can vary across the mid-market, dependent on the sophistication of financial reporting. Through the increased use of data analytics tools, RSM can often derive and analyse trends in MRR and ARR even if the business does not perform such analysis regularly, providing valuable insight into the business’s underlying performance.

Customer behaviours

ARR and MRR trends can be driven through multiple customer behaviours, which can again provide insight as to the real value in the business’ underlying ARR;

Customer retention 

A lack of customer retention (often considered anything less than 90%) can indicate ARR, which is less valuable to a potential purchaser, as notable new customer onboarding is required each year to simply maintain revenue levels, which can be expensive. Similarly, high customer retention can potentially increase a business’ valuation as this could be perceived as a ‘cash cow.’

Customer upsell and downsell

Trends in MRR and ARR are also impacted by customer upsell and downsell, the increase or decrease in spend by a customer year on year. A business demonstrating strong customer upsell can again potentially increase the perceived value to a potential purchaser.

These factors must be analysed. An effective method is to bridge ARR from period to period, with the drivers of the movement being customers won, customers lost (churn), customer upsell and customer downsell. An assessment can, therefore, be made of each bridging item and the factors that impact them, delivering key insights to the profile of recurring revenue a potential purchaser is acquiring.

Impacts of revenue recognition and billing

It is common in the middle market for acquisition targets to not defer revenue in line with AASB 15.

The importance of compliant revenue recognition

It is common for SME businesses in the technology sector to recognise revenue in full-on invoices rather than in line with accounting standards (AASB 15), whereby the revenue is to be recognised over the lifetime of the contract. The effect of this has a dual impact: the underlying earnings of the business and the inclusion of deferred income within working capital or net debt (see below).

It is critical that a due diligence practitioner identifies the appropriate accounting treatment and calculates the impact of revenue deferral from both an earnings and a balance sheet perspective.

Impact of deferred revenue on a deal structure

The treatment of deferred income in a transaction is a common topic of debate, with a vendor typically positioning it as working capital, which results in the most favourable equity value position at completion. It is essential to understand the rationale that drives each side of the debate to arrive at a fair and equitable position for both parties and ensure nobody loses out due to the mechanics of the calculation at completion.

Deferred income to be treated as debt

Deferred income may be considered as debt in the following situations:

Cash-backed deferred income

If the business has received the cash in advance of providing the service the balance can be considered as debt on the basis that this offsets the cash on the balance sheet against which the vendor has provided no service. This means the burden of providing such a service will sit with the new shareholders, and hence, it may be considered fair that the buyer receives the cash benefit for this obligation.

Costs to service 

Where deferred revenue exists, a common approach favoured by the vendor is to treat the future costs to service the deferred income as a debt-like adjustment rather than the entire deferred income balance. This, in effect, attributes the cash profits of the service to the vendor, which would not be considered a favourable position for a potential purchaser.

Deferred income to be treated as working capital

Debtor-backed deferred income 

Where a deferred income balance is recognised, but no cash has yet been received, meaning the corresponding debtor sits within trade receivables. In this instance, it is considered fair for this to be treated as working capital as the balances offset. The total deferred income balance is often split between debtor and cash-backed, with the treatment differing for both balances.

Consistent, recurring balance

It may be argued that the deferred income balance will not unwind, with the balance being consistent month-to-month historically and not presenting a future cash outflow to the potential purchaser post-completion.

No costs to service

Some subscription services in the technology sector are simple on/off switches. There are no incremental costs to the business for an additional subscription. In this case, the vendor may argue that there is no future cost to service the deferred income and, therefore, it should receive the value benefit for this by treating the balance as working capital.

There are rebuttals to all arguments dependent on the side of the transaction you sit on. A due diligence practitioner needs to identify the key characteristics of the deferred income balance to ensure no value is being lost for their client through the treatment of the balance at completion.

Earnings multiple

EBITDA is not always the most appropriate earnings multiple due to the high value of costs being capitalised on the balance sheet.
Impact of development costs being capitalised

A multiple of EBITDA is typically used in a transaction when generating a valuation, as it is a proxy for the cash generation of a business. In the technology sector, this can be considered less appropriate, where businesses spend heavily on development costs, which are capitalised on the balance sheet and amortised over a longer period rather than expensed directly on the P&L.

Large portions of the capitalised costs reflect an ongoing cash expense to the business, a primary example being personnel costs for software developers. The business is expected to continue to innovate and, therefore, employ such personnel, meaning the costs may be considered within the valuation method.

There are commonly two ways to treat this:

• EBITDA less any costs capitalised in the period or
• EBITDA, meaning the amortisation attributable to the intangible assets developed, will be included as a proxy of the ongoing cash costs of the business.

Run-rate earnings

Once a method to attribute costs for the ongoing intangible asset development has been determined, a further consideration is whether a traditional 12-month accounting period should be used for a valuation multiple or whether a run-rate method could be adopted.

Run-rate earnings are particularly relevant for Technology businesses due to the presence of ARR, meaning value is attributed to the revenue secured for the next 12 months rather than the revenue achieved in the prior 12 months.

For a business growing throughout the last twelve months, this method would likely result in a higher earnings figure.
A rigorous review of such a calculation must occur, with risks such as historical churn being factored in and ensuring all the appropriate cost levels are included on a similar run-rate basis.

A thorough understanding of the key deal metrics, revenue recognition risks and the nuanced earnings multiple is essential to undertaking a robust financial due diligence process that drives value and mitigates risk. Understanding underlying cash flows, key valuation drivers, key performance indicators, and accurately evaluating net working capital and debt-like items are critical to ensuring a successful transaction outcome.

Should you have any questions on the topics discussed, or you wish to seek support on any future transactions, please feel free to reach to Glyn Yates.