Acquiring companies go through a due diligence exercise to help ensure there are no surprises after the deal closes. The due diligence typically takes place once an offer has been accepted by the acquiring company, pursuant to number of conditions being fulfilled, one of which would be the completion of the due diligence.
Many companies require organizations to provide assertions, which become part of the purchase agreement. These declarations provide a framework that allows the acquiring company to take legal action against the owner if it is not consistent with the business practices. For example, the purchase agreement might state that all client contracts do not have an exit clause on ownership transfer. If subsequent to the close of the deal, it is determined there were a number of contracts that did have exit clauses, it could provide grounds for litigation against the owner.
The acquiring company may deploy a team onsite, or provide the owner with a list of information they want to inspect. This will become a time consuming exercise, if the information requested is not readily available. There are 7 main areas of due diligence where companies will focus on. Below is a summary of each area, along with a brief description of some of the activities that will take place.
Sales and Marketing
Activities that would be included here would be focused on the sales and marketing process along with the methodology relating to the forecasting approach that will feed into budget. As any valuation of the company would look at the future forecasted revenue streams, the acquiring company would want to be comfortable with how the forecast is put together. Furthermore, understanding the sales and marketing group will help the acquiring company in determining the areas of overlap within their organization and help assess the quality of the team.
Understanding the operations of the company will assist the acquiring company assess the overall day to day operations of the acquired company. The steps related to client on-boarding would be reviewed, along with the ongoing activities with the client. The project management approach relating to client on-boarding is reviewed here, to determine the risks associated to implementing new clients. Other activities such as account management, support levels and client turnover are reviewed.
An analysis of the financial statements is performed to understand the assets/liabilities, along with the types of revenue and expense. As the financials tie in directly to many areas of the business, there is often overlap between this area, and that of the other review teams. A properly structured due diligence team will manage this in an efficient manner. For example, the pricing of products is normally a marketing function, but the profitability of products has a direct relationship to the profitability of the company.
Depending on the size and type of organization, this level of effort here can vary significantly. If the company is a public organization or has activities in multi-jurisdictions, the review here would include a number of activities. A review of SOX Compliancy would often be a topic for this section. Transfer pricing would be reviewed in the case of multi-national organizations. Tax filings compliance would be covered here as well, and would include both corporate and State/VAT taxes.
Understanding the company’s infrastructure is important. Items like real estate, corporate networks, both network and physical security and others would be discussed to understand incompatibilities and identify areas of vulnerability.
The people in a company is a key component of any acquisition. It is critical for an acquiring company to understand the employee policies and procedures that are in place. Furthermore, key resources are identified and the plans in place to reduce turnover of those individuals are reviewed here. Turnover statistics are analyzed as well to help identify any potential staffing risks.
This is another critical area of review and covers many areas. Most of the key client/supplier contracts are reviewed, along with the letters of incorporation, board meeting minutes and employment agreements. Any outstanding litigation or recently settled litigation is reviewed as well.
Once an agreement in principle has been reached, both parties will want to bring the deal to conclusion as soon as possible. As a result, the due diligence phase will be on a tight timeline. It is important that the acquiring company is organized and is prepared for this phase. The inability to provide information to the acquiring company on a timely basis can cause the deal to collapse.
As a result, companies wanting to sell their business should ensure they are prepared internally for this step, well in advance of the sale. As part of the annual planning process, companies should perform a readiness assessment and determine if there are areas that need to be addressed. While a company can not anticipate everything that may arise during the due diligence process, most of the potential issues can be alleviated.
When the time comes to sell your software product business, proper preparation, which can take several years, can affect the value buyers will assign to your company and help ensure a successful transaction. The video below goes through 8 factors to consider and work on when preparing the exit strategy for your software business.
Owners of a software company need to be thinking about how to grow the value of their company. Understanding some of the factors can help with strategic decisions to drive maximum shareholder value.
A software company will typically be valued by a buyer or investor on factors beyond the financial projections and future cashflows. Financial buyers that are making their decisions primarily on a cashflow basis, will often offer low valuations, compared to a strategic buyer. The factors will often be unique to each possible buyer, which makes it important for the seller of a software company to try to understand a buyer’s motivation.
Some of the factors beyond financials include:
Client Base: A software firm’s client base can have a significant impact on a valuation. For a buyer, if a target firm’s client base can expand their market or provide a complimentary solution for their IP to increase the revenue from their client base, this has value to the buyer. In some cases a buyer will be looking to diversify out of their core market and will use an acquisition to buy entry into new markets for their existing products.
Intellectual Property: How unique is your firm’s IP and what would be the cost to replicate? Ideally your firm has IP that would be expensive and difficult to replicate, which creates a barrier to entry for competitors and allow for a higher license fee. A software firm must have clear ownership of their IP. Where contractors or offshore development is used, legal agreements must be in place to clearly define that ownership of the software resides with the software company.
People: How depended is the business on key individuals, especially if they are founders/large shareholders? It is common after an acquisition for founders and large shareholders to move on after a period of time (see blog on Why Do Owners Leave after Selling Their Companies). The buyer needs to know the organization will continue to operate and grow without the founders. High turnover, or a heavy reliance on contractors that may not be committed to the firm would be factors negatively affecting the value of a software company.
Strategic Relationships: If a software firm can provide a buyer with strategic relationships that they do not already have and would be difficult to get, this will have value for the buyer. When negotiating strategic relationships and partnerships, it is important to try to limit clauses that may limit assignment of the agreement in the event the software company is sold.
Revenue Sources: Buyers love recurring software revenue. From a buyer’s perspective, a question can be: “what am I left with if everyone quits after the purchase is completed”. Contractual recurring revenue provides a predictable revenue stream and will be given a higher value when it is included with the buyer’s financials. Software companies should look for opportunities to make non contractual revenue that recurs into contractual recurring revenue. In many cases a client may prefer an annual predictable commitment that can be budgeted.
Company owners/founders typically don’t last long after a sale. The time period is normally influenced by incentives the buyer puts on the owner to stay. Often the incentives are tied to revenue or profit targets. But the acquirer may want to have control over their acquisition. The owner goes from being responsible for results and making decisions, to being responsible for results and having minimal decision making authority. The degree to which the acquirer allows the owner/founder to retain decision making as well as how achievable the targets are viewed, will affect the retention period. Small business owners do not work for big companies because they like being able to make decisions and being fully responsible for results.
Another factor is many sale agreements have an escrow or holdback that can be clawed back if the selling owner does certain actions. While reasonable, it places a higher standard for owners to follow company policies to the letter. While a regular employee can bend the rules to achieve desirable results, the owner can face significant financial penalties through escrow or holdback claw back.
What can an acquirer do to help retain a founder/owner (assuming this is desired). First, look to what the owner contributed and allow them to focus on that area. Most owners have a specific skill set, which can be sales, operations, product development. The benefit for the acquirer is they gain a resource that is likely very good at what they do, based on the results of the company that drove the acquisition. After selling my first company, while my contribution was sales, the acquirer wanted me to report to the CFO and manage investor relations, including producing the annual report. I left shortly after to start my second company.
Another way to retain an owner is to continue to provide a level of decision making. Unlike other employees, the acquirer has a level of protection that that owner’s decision making will be appropriate during the period when the escrow is outstanding.
Too often selling owners believe they will stay with the acquirer after the sale is complete. While it happens sometimes, most times the owner will move on to form a new company because of the reasons noted above. At the same time, the acquiring company may assume the owner will stay for a period of time due to incentives and how they view employees. If the goal is to retain the owner for a period of time to benefit from their experience and knowledge, an acquirer needs to look at what will achieve retention from the selling owners perspective, not their own. The upside is it can be a win/win for the acquiring company and selling owner.
Most software companies don’t think about whether they are creating an app or platform when they start out, but the decision can affect revenue growth and valuation. Deciding what you are building is a key strategic decision.
If building an app, the goal is to be a completely encompassing solution and possibly have integration API’s to enable data exchange with other complimentary solutions, such as a CRM or accounting system. If building a platform, you are providing technology for your partners to extend your core functionality. As a platform solution, the focus is building a robust tool set for partners to build on, while being mindful to not compete with your partners solutions built on your platform.
As an application software vendor, you may have partners that build integrations, but it’s likely the partner apps are not reliant on your application and they may also build integrations to your competitors. A platform has partners that have solutions that are reliant on your platform for the delivery of their solution. Salesforce, Microsoft or Facebook are platforms that software companies build solutions on.
We believe a platform is more difficult and costly to build, but will have greater revenue growth and longer term value. The solution provided to prospects and clients will be more comprehensive as partners extend functionality to address client and prospect requirements, which will ultimately expand your addressable market. It is difficult for a single vendor to build a solution that meets all prospects needs, which is why the largest most successful software vendors build platforms. Software products built on a platform will create demand for the platform as your partners sell their solutions and open new markets.
Why build an app? Software applications are less costly to build and faster to get to market. If the target market is relatively small, there may not be enough potential to attract partners to build on a platform. The app may also be more conducive to integration to other applications such as a CRM or accounting system.