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When contemplating the acquisition of a software company (or any company, for that matter), the number of variables that potential purchasers must consider is overwhelming, and as a result it would be impractical to discuss all such variables in a single blog post of reasonable length.
For this reason, what follows is by no means an exhaustive list, but is instead a curated list of certain non-obvious considerations for the prospective software acquiror to consider based on my own experience acquiring, running, and selling a small- to medium-sized software company over the course of many years. Specifically, for every topic that I profile below, I discuss why it’s important to dig one level deeper than the simple “headline” numbers and conclusions.
Though the number of variables that you will consider will far exceed those which I present below, I hope that something contained within will prove to be helpful to you as you navigate your own due diligence process.
In this blog post I will discuss only financial considerations, while in my next blog post, I will discuss non-financial considerations.
Digging One Level Deeper: The Accounting Treatment of Software Development Costs
The costs that are incurred in the process of a company actually developing their software can have a different accounting treatment depending on the unique circumstances in question. Certain development costs (salaries for those doing the coding & testing, external vendor costs, and so on) can either be:
- Expensed: Costs are expensed to the income statement in the period in which they are incurred, decreasing near-term profitability, all else being equal; OR
- Capitalized: Creation of an asset on the company’s balance sheet, which is then expensed to the income statement over time, increasing near-term profitability, all else being equal
Although the specifics details around what costs can be expensed versus capitalized are beyond the scope of this blog post, prospective acquirors must recognize that two identical software companies producing two identical products can theoretically present two vastly different EBITDA profiles based solely on how they choose to account for certain software development costs. This risk becomes particularly pronounced when the financial statements are unaudited (which is reasonably common among SMBs), as the accounting treatment decision was likely made without external guidance from a qualified CPA. This difference in turn could impact the purchase price that an unsophisticated acquiror is willing to pay, particularly if the price is being computed as a multiple of the company’s EBITDA.
Sophisticated acquirors will recognize that differences in the accounting treatment of software development costs are largely “cosmetic” in nature, and will leverage their financial advisors to retroactively expense any costs that might have been previously capitalized to get a true picture of the company’s operating profitability, and to more accurately compare the financial profile of the target company to those of its peers.
Digging One Level Deeper: Professional Services Revenue
Almost all software acquirors rightly value product revenue (typically expressed in the form of Annual Recurring Revenue, or “ARR”) at much higher multiples than they do service revenue (generally per-hour revenue generated in the set-up, implementation, and/or configuration of the product). Indeed, it’s not uncommon for acquirors to value ARR at multiples of 6.0x or more (especially as of this writing, in October 2021), while often valuing service revenue at 1.5x or less.
Although it’s well established that product revenue is indeed more valuable than service revenue in most cases, it’s important to recognize that not every dollar of service revenue should be valued equally across all companies. For this reason, it isn’t prudent to judge any given company’s revenue profile as inherently good or bad based solely on the percentage of total revenue represented by professional services, even though many unsophisticated acquirors tend to do just this.
Here are some dynamics that would make me more comfortable with a higher ratio of service revenue to total revenue. The more of these that apply to your target company, the better:
- The service work mostly comprises efforts to integrate the product in question with other important systems of record in the customer’s technology environment
- The service work is largely configuration, and includes no customization specific to any given customer (customization is a word that you should listen carefully for. If you hear it too frequently, run in the opposite direction!)
- The service work never requires any new code to be written (implementations that are regularly slowed down by feature requests or escalations from the Service group to the Engineering group should serve as a red flag)
- Because the product is slated to be rolled out across multiple departments within the customer’s organization, the implementation requires multiple stakeholders across multiple customer groups
- Because the product is mission critical to the customer’s operations, and/or because it is likely to be used very frequently, extensive product training is required
In effect, most software that is difficult, time consuming, and/or costly to put in tends to be equally as difficult, time consuming, or costly to take out, resulting in higher switching costs and customer stickiness (this should be validated by analyzing the company’s customer retention numbers – more on that below).
However, this is only true if the implementation work is difficult, time consuming, or costly for the right reasons, like those mentioned above. If implementations are complex, time consuming or expensive for the wrong reasons (eg: lack of product scalability, required customizations, poor product architecture, old technology, etc.), then the prospective acquiror would be wise to proceed with a healthy dose of caution.
Digging One Level Deeper: Deferred Revenue and GAAP Compliance
Software companies that operate under a subscription revenue model tend to have large balances of Deferred Revenue on their balance sheets, which represents their remaining obligations to those customers who have already paid for their software, but who have not yet received the full benefit of usage across each month for which they have paid. Companies who bill and collect the full value of their contracts upfront (which should always be the preference due to its favorable impacts on the working capital cycle) tend to present higher deferred revenue balances than those companies who bill and collect more frequently (say, monthly or quarterly).
Acquirors would be well served to thoroughly diligence Deferred Revenue alongside their financial advisors (ultimately with a view towards calculating it in a GAAP-compliant manner) because:
- Many companies, particularly in the SMB ecosystem, don’t account for deferred revenue in a manner consistent with GAAP. This is especially true for companies whose financial statements are unaudited, and/or for those who don’t have adequate financial controls in place
- Differences in how deferred revenue is accounted for can, in some cases, materially over- or under-state revenue (and, in turn, profitability) which may impact the purchase price
- Because Deferred Revenue tends to be among the largest balances within the “Current Liabilities” section of the balance sheet, differences in how it is accounted for can materially impact the working capital adjustment, which is typically done anywhere between 30-120 days after the consummation of the acquisition (I’d recommend reading my blog post on the working capital adjustment here ) (Author’s Note: Link will not work until that blog post is published)
Digging One Level Deeper: Customer Retention
Though you will analyze countless financial and operational metrics throughout the course of your due diligence process, I would suggest being particularly thoughtful and analytical around customer retention, or the rate at which the company is keeping its existing customers (the inverse of retention is called churn, which is the rate at which the company is losing its existing customers). Unsophisticated acquirors may spend most of their time looking only at gross logo churn, but doing so would ignore a lot of other important information.
Retention can be broken down into two primary categories, each of which presents two different options (for a total of 4 main churn metrics) *. They are:
- Customer Retention: Essentially answers “What percentage of my customers from last year are still customers this year?” (This is sometimes also referred to as “logo retention”)
- Dollar Retention: Essentially answers “What percentage of my recurring revenue dollars from last year are still recurring revenue dollars this year?”
*I’ve chosen an annual measurement period here, but these same metrics can be measured on a monthly or quarterly basis
Each category above is then broken down into either a “Net” or a “Gross” value, each of which communicates different types of information:
In the case of Customer retention, the “Net” value includes the effect of new customer acquisitions, whereas “Gross” counts only those customers who have left. For example, a company with 100 customers who loses 5 customers in 2021 but acquires 3 new customers that same year has a “net” logo churn of 2% (net logo retention of 98%), and a gross logo churn of 5% (gross logo retention of 95%).
In the case of Dollar retention, the “net” value adds the dollar value of upsells, and subtracts the dollar value of downgrades or lost business by customers, whereas the “gross” value does not. For example: A company with $100 of recurring revenue and 5 customers at the beginning of 2021 experienced the following over the next 12 months: i) Lost 1 customer that had been paying $7/year of recurring revenue; (-$7); ii) Had an existing customer who had been paying $10/year upgrade their system to a level where they are now paying $15/year (+$5); iii) Had an existing customer who had been paying $12/year downgrade their system to a level where they are now only paying $10/year (-$2). In this case, net dollar churn was -$4 (or 4%, the sum of each of the gains and losses listed above), implying a net dollar retention rate of 96%. Gross dollar churn was -$7, or 7%, as it includes only the dollar value of the customer that was lost.
Spending a lot of time analyzing retention is incredibly important simply because it can tell you so much about any given software business. Among other things, it can tell you about the quality of the product, the competitive dynamics in the marketplace, the effectiveness of sales & marketing efforts, customer stickiness and switching costs, and pricing power.
Though this may sound obvious, no churn analysis would be complete without i) Analyzing how churn (ideally each of the 4 types mentioned above) has been trending over each of the past 5 years; and ii) An attribution analysis (i.e. for each customer lost over the past 5 years, an understanding of why they left).
Attribution analysis is particularly important because not all churn is created equally. For this reason, simply looking at the headline retention numbers is not enough. For example, did your target company see a spike in churn this year because their industry was in the midst of a temporary recession (less worrisome), or was it because their software utilizes old technology that the major browsers no longer support (more worrisome)?
Digging One Level Deeper: Lifetime Value of a Customer and Customer Acquisition Cost
Alongside a handful of other metrics, almost no financial analysis of a software company would be complete without analyzing the ratio of the lifetime value of the average customer (“LTV”) expressed as a multiple of the average cost to acquire a customer (“CAC”). In some cases, the simple headline numbers can be misleading if you don’t understand the discretion that is often applied when calculating LTV/CAC. Before I provide you with a few examples, note how LTV/CAC is calculated:
For the sake of brevity, here are just a few examples of why it’s important to dig one level deeper than the simple headline numbers:
- Not all software companies necessarily calculate gross margin in the same way: For example, some include sales commissions within COGS, whereas others include them below gross margin as part of their payroll expense
- What if the company is too young to even know their average customer lifetime?
- Average customer lifetime can change over time: For example, a company with a 5% churn rate would theoretically have a customer lifetime of 20 years (1 / .05 = 20). However, what if that company had minimal competition over most of their operating history, but now suddenly the market has been flooded with new, well-capitalized entrants? What if the company had relied on old technology and had under-invested in their platform, and is now using a technology stack that is being deprecated? Can we still expect customers to stay for an average of 20 years if, in 2 years’ time, the current version of their software will be unusable?
- The amount of sales & marketing spend required to acquire $1 of ARR can and should differ depending on where that ARR is coming from: For example, it tends to be much more expensive to acquire $1 of ARR from new customers, and much less expensive to acquire $1 of ARR from existing customers via an upsell
Digging One Level Deeper: The Temptation of Small, Highly Profitable Software Companies
Recently, I’ve had several prospective acquirors approach me with the opportunity to help finance their acquisitions of very small but highly profitable software companies. These targets tend to be very small (<5 employees, usually with <$2M in annual revenue), slow growth (<5-10% annually), have highly profitable operations (EBITDA margins > 50%), and be quite founder-centric. The basic investment thesis that these prospective acquirors tend to present is that the founder has created a “lifestyle business” and has not actively pursued growth, instead electing to extract cash from the business every year to finance their desired lifestyle. These founders are often technical in nature, in many cases having built the initial version of the product themselves 10+ years ago. While this thesis can indeed make sense in certain instances, I tend to advise these prospective acquirors to proceed with caution for the reasons below. Note that none of these are necessarily universally true or applicable, but instead represent things that you should look out for if you find yourself interested in acquiring a company like this:
- Sometimes, acquiring companies of this size is more akin to purchasing somebody else’s job than it is to acquiring a true going-concern business
- Assuming that the new owner is interested in pursuing growth, those high EBITDA margins are very unlikely to persist, due to the negative correlation between growth and profitability
- Companies like these often (though not always) under-invest in their people, tools, processes and systems. If this describes your contemplated target, then the profitability profile that you see on their current financial statements likely doesn’t represent the true profitability profile that the business will yield under your ownership
- Despite their high cash flow margins, because of their small size these companies often present a dollar value of annual cash flow that can be insufficient to finance future growth initiatives. For example: If your company only produces $400K of cash flow annually in its current (very small) state, unless you have access to other sources of capital (debt, equity, or cash on hand), you don’t have much money to finance the various growth initiatives that you’ll need. Indeed, one talented VP of Engineering and one talented VP of Sales can consume the entirety of your annual operating cash flow
- Sometimes, these businesses are still small for a reason. Though it is possible that the owner is satisfied with the current size of the company and/or is commercially unsophisticated, it is equally possible that the market is small, competitive, saturated, or contracting.
- You’ll want to have a thorough understanding of where future growth is likely to come from, because all sources of growth are not created equally. For example, in some industries, penetration of the type of product being sold is low, so most sales opportunities can be “greenfield” in nature, meaning that there is no need to replace an incumbent provider of a competing product (this is preferable). In other instances however, the market may be more saturated, meaning that any new sale will require a customer to replace the product of an existing provider (this is much less preferable)
Acquiring any company is difficult for a multitude of reasons, not least of which is the sheer volume of information that needs to be processed and understood. In the case of acquiring software companies, there is considerable value in going beyond the simple headline numbers to ensure that you have an appropriately nuanced understanding of all of the relevant dynamics at play. Though I’ve profiled a handful of financial considerations above, note of course that there are many others to consider.
To make matters more complicated, financial due diligence is only a part of the whole due diligence process! Equally if not more important are the product-specific considerations that you should understand before parting with any capital. These non-financial considerations will be the focus of my next blog post, Considerations Unique to Acquiring a Software Company (Product)
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