As conversations continue over due diligence for technology companies, it is important we build off of Key Areas of Due Diligence for Technology Companies from 2023 and work our way into the forecast ahead in 2024.
Podcast Spotlight: Due Diligence for Technology Companies
Listen in to this episode of The Capital Table as Steve Brady, Market Leader of Transaction Advisory at Withum, and John Schrumpf, Transaction Advisory Manager, discuss key areas of due diligence for technology companies.
Previously, we’ve covered the detailed accounting and financial reporting issues that technology and emerging growth companies run into when going through financial and tax due diligence for an M&A transaction. Moving ahead, after the slowdown of activity in both the overall M&A market and the technology sector that began in 2022, activity is trending upward through the first three quarters of 2023. Software deals, specifically, accounted for more than 70% of overall technology deal volume and have shown strong improvement in the first half of 2023. Deal volume for software companies has shown an increase of approximately 20% compared to the second half of 2022 [1] . As with other subsectors, this upswing in deal volume is driven by a surge in the number of smaller deals, at lower valuations compared to the peaks in 2021.
A wide range of M&A experts have projected for these positive trends to continue, and for the overall M&A market to experience continued increases in activity in 2024. In anticipation of a potentially hot market in 2024, buyers and sellers in the technology sector can benefit by starting now to prepare themselves to address key areas that arise during the due diligence stage of a transaction.
Top 5 Key Due Diligence Areas for Tech Companies
- Customer KPIs: Outside of the standard reported financial metrics (e.g., total revenue, gross margin, net income, EBITDA, etc.), due diligence procedures will also consider the quality of revenue and customer composition. Customer KPIs will vary depending on the specific operations of the company. Common KPIs analyzed in the technology sector include the following:
- Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR): Together these metrics provide insight into the predictability of revenue while accounting for growth in customer base. Recurring revenue (both annual and monthly) are particularly important metrics for software companies.
- Customer Retention: While ARR and MRR are important metrics, their value is dependent on customer retention. High customer retention provides confidence that a company will fully realize ARR and MRR, while low retention would be a cause for concern in due diligence.
- Customer Acquisition Costs (CAC): At a basic level, customer acquisition costs are calculated as the marketing spend required to obtain a new customer. More detailed calculations can include marketing and sales employee salaries, sales commissions, and any other identifiable costs related to obtaining new customers.
- Customer Lifetime Value (LTV): Typically viewed in direct relation to customer acquisition costs, customer lifetime value represents the total revenue expected to be generated over a customer’s life. A more detailed calculation can factor in expected customer churn. The LTV:CAC ratio can help companies determine appropriate level of sales and marketing spend.
- Customer Concentrations: Concerns around customer concentrations typically arise for B2B companies that have lower customer counts. The risk of losing a customer can be a major concern during due diligence. Concerns around customer concentrations for B2C companies are related to geographic or demographic concentrations that may indicate a limit on the total potential customer population.
- Cost Sustainability: While customer and revenue metrics may be a primary concern for technology and early/growth-stage companies, it is also important to establish a sustainability cost structure. Key concerns related to cost sustainability can include vendor relationships and concentrations, long-term vendor contracts or commitments, employee retention/turnover or significant open positions, and even employee/subcontractor geographic locations.
- Cash Management: It is imperative for companies seeking capital to demonstrate responsible and sustainable cash management. Cash management includes timing and speed of collecting receivables compared to making vendor payments, the ability to obtain credit facilities, and maintenance of appropriate spending levels while still investing in future growth. Key metrics include average net working capital and free cash flow analyses.
- Ownership of IP: Companies in the technology sector are frequently built around or rely on proprietary software or other IP. Prior to entering due diligence, it is important to have an established legal ownership of such assets and detail any existing licensing agreements or assignments of IP.
- Cybersecurity & IT Environment: Similarly, as many companies in the technology sector revolve around software or other web or cloud-based platforms, cybersecurity is a vital component of due diligence, as any weaknesses could hold up or derail the deal process. Cybersecurity is particularly important for companies that host customer information or other sensitive data. Detailed cybersecurity policies and procedures can help mitigate any buyer concerns.
Before entering an M&A transaction, as either a buyer or a seller, it is important to understand the potential impact of each of the above items. A strong grasp of each of these key items can ensure a smooth transaction process and mitigate post-transaction risk.
Author: John Schrumpf | [email protected]
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