Common Issues Encountered During Buy-Side Due Diligence in Software Companies

Assessment of Recurring Revenue and Customer Base

Many software companies have recurring revenue contracts for the software to be used over a contract period. One of the primary aspects of due diligence is the assessment of recurring revenue and the customer base. This goes beyond merely reviewing the most recent income statement. It involves a thorough analysis of the quality of earnings, which includes understanding the sustainability and predictability of revenue streams. An important step in the due diligence process is the need to scrutinize the customer contracts, renewal rates, and the overall satisfaction of the customer base. This helps in identifying any potential risks related to customer churn and can identify revenue concentrations.

During this process, it is also crucial to assess the company’s cash flow management practices and the efficiency of its customer collections process. Understanding the timing of collections and how much of a target company’s projected future revenue is already collected will greatly impact the value of the target. If most of the future recurring revenue contract value has been collected already, the balance sheet will show a large deferred revenue liability that would be acquired by the buyer in the acquisition. Therefore, understanding the cash flow dynamics and customer collections is essential for making informed investment decisions.

Cybersecurity and IT Due Diligence

In today’s digital age, cybersecurity and IT due diligence are critical components of the due diligence process. It is essential to have tech experts review the security measures around the software and applications to ensure they were built with best practices and are free from vulnerabilities. This includes evaluating the company’s data protection policies, encryption standards, and access controls. Moreover, it is crucial to review for indicators of previous breaches or the potential for future breaches. This can involve examining the company’s incident response plans, past security incidents, and the overall security posture. Ensuring the proper cybersecurity measures are in place throughout the target can mitigate the risk of acquiring unforeseen liabilities and allow for a smooth integration of the target into the established business.

Projections/Forecast Reasonableness

Another critical aspect of due diligence is assessing the reasonableness of the target company’s projections and forecasts. Management needs to get comfort with the assumptions and methodologies used in the financial projections. This involves analyzing the historical performance, market trends, and competitive landscape. It is essential to engage with the seller’s management team to understand the basis for the growth assumptions and whether they are realistic and achievable if acquired. Additionally, stress-testing the projections under different scenarios can provide insights into the potential risks and opportunities. Buyers should also create their own projections with their plan for how they will integrate the target company within their business to ensure it is in line with their own forecasts. This would include focusing on the cash needs to operate and integrate the target company and understanding when to expect the company to be cash flow positive.

In conclusion, buy-side due diligence for a software company involves a comprehensive assessment of various factors. By thoroughly evaluating the revenue and customer base, conducting rigorous cybersecurity and IT due diligence, scrutinizing the reasonableness of projections and forecasts, and understanding the cash flow expectations, investors can make informed decisions and mitigate potential risks. This holistic approach ensures a better understanding of the target company’s value and future prospects.

At Schneider Downs, our professionals on our Transaction Advisory Services team can assist buyers of software companies by performing a quality of earnings and financial due diligence assessments. This process assesses both financial and non-financial risks such as cybersecurity, operational and tax risks. Schneider Downs has a proven track record of assisting buyers, sellers, investors, private equity firms, and lenders in evaluating the financial integrity of businesses involved in M&A transactions.

About Schneider Downs Emerging Technology Services

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