Identifying Risks in Software M&A

‍Text Version of the Interview

What is Technical Due Diligence?

When you're thinking about software deals, there are a couple of very important points when you're doing the technical due diligence that I like to focus on. Code audit and Cyber security.

A code audit is where they are focused on checking on the quality of the code and for any open-source site issues. 

So you want to make sure that the code is well written and that it's scalable. It's essential that the code is scalable and can be leveraged well, potentially for other uses that you can later add to realize your synergies. 

And then you want to make sure that it's well documented, so people who might've written the code have left, you're able to trace them, make changes, and you know how that works.

The second point that I mentioned is the open-source check. So usually, it's done by the same types of folks, often a third party, where they run checks to make sure that none of the code or at least not very large portions of the code are sourced from open source resources. 

If you have open-source, which is out there on the internet, anyone can find it for free and incorporate it. 

The problem with that is if you incorporate that kind of code into yours, you might be required by law to provide your software out in the public. 

So whatever your output is, you may not be able to have clean ownership rights and potentially might have to share. 

You might be forced to share your code with everyone out there. Even the value-added stuff that you've designed, just because of that input that you took advantage of. 

Another piece that I always look at is the technical team review. You'll want your business sponsor and the IT leaders to come out, look at the code to test it out, and make sure that it's working the way they want it. 

The last point I would mention is very important to look at your cybersecurity setup. And possibly test out what the cybersecurity gaps could be. 

So in some cases, you would have a team trying to hack into the target and pressure testing these. In some cases, you will just have other means to identify these cybersecurity gaps. 

HR Challenges Specific to Software Company 

When you talk about software specifically, you have to understand your life cycle for onboarding developers and salespeople. 

I've seen in some cases where it takes a long time to onboard a developer. It takes a long time to get them up to speed on how the company writes code. That could take six months, even more than a year.

The same thing is for salespeople to learn the software and the technical aspect of the product. You have to be very cognizant of what your current workforce is. 

Make sure you give them time to set up and be productive, ensuring that they're operating on a high level. 

Employees Who Require Visa

You always have to check what the status is. Is this person going to be impacted by an M&A deal? 

Sometimes, when you're doing an asset deal where you buy the company's assets, you will actually terminate the employees and then hire them at the new company. 

That could cause issues for some people because you haven't done the paperwork, or you may take some time to do the paperwork for that person to be transferred or the visa to be adjusted. 

So that's something that has to be done well ahead of time so you're not impacting those people. They're not losing their eligibility to stay in the country. 

The other point I've seen, every once in a while, you'll see popping up is that for certain kinds of visas, the employees are required to have a certain amount of years under their belt to qualify for those types of work permits. 

Any Other Red Flags?

One of the most critical pieces is making sure that the founders of the management team are motivated and excited to join your company and want to continue contributing and dedicating their full efforts to that. 

Beyond the first layer of the founder, CEO, and maybe a couple of others, who are the next level down, are the most important people we need to make sure are motivated. So potentially looking at retention strategies for them from compensation and other types of motivational strategies. 

How Tax Issues Affect Deals? 

Tax can be quite important and sometimes deal-breakers. 

For example, You'll have a corporation. It's a kind of corporation that is a flow-through, it's called an S-corporation. The owner just reports the income from it on their tax return. They have to be set up in a very, very specific manner. 

Document A has to be filed before document B with the IRS. Otherwise, your whole setup could be in danger, and you may not even know that you haven't done it the right way. 

Sometimes a founder thinks they're starting a mom-and-pop shop and they do the filings themselves online. 

And then 20 years later, it's a huge company with a lot of revenue and many employees. And then you only find out when you're doing an M&A process that you didn't file document B after document A. That should be in the right order and your whole setup is entirely at risk. 

So instead of an S-corporation where you have your income flowing through to you and you're not paying taxes on the corporate level. You could be in danger of being deemed a C-corporation, where you would actually have to pay taxes at that level. 

And also, if you're doing a special kind of transaction where you might be doing a stock deal but want to treat it as an asset deal for tax purposes, we refer to it as a 338H10 exchange. 

It cannot be done if you didn't file your S-corporation documents correctly, which can significantly change the economics as a buyer. Or the founder can be deemed to be owing all these taxes going back, let's say 15, 20 years to whenever they founded the company, depending on what their revenue could be tens of millions of dollars. So a huge issue and very difficult to solve. 

I also find that sometimes I've seen cash flows between related entities where people pay management fees from the left hand to the right hand; it can be fine when you're in a small environment. 

But when you're dealing with a larger corporation, acquiring them, this kind of thing will be scrutinized by the IRS. So you definitely want to make sure that that's mitigated by various means. 

And then I would just mention very briefly, I've seen a lot of state and local tax issues with software companies. 

It's an interesting one because you might be selling software to a client in a different state and haven't filed your local income tax returns, or maybe didn't file them in all the States that you're supposed to.

And again, that could be over years and years and years could adapt to some significant money as well. 

How To Mitigate This Risk? 

So it depends on very different fixes depending on the situation. But the example I gave about the S-corporation, in some cases you can actually go to the IRS and ask for forgiveness essentially. 

So there's a program for these kinds of things where it was an honest mistake, and you didn't do it on purpose; they will give you a grain of amnesty. So that's something that can be done. 

And the other thing is there's this whole industry that developed over the last few years about tax insurance for M&A deals specifically. So there are folks that will underwrite these types of risks. 

And then for state and local taxes, no, you can do something similar or you can usually those are much smaller, and you can set up escrows for that. Let's say for a couple of years; nothing happens, then escrow is released to the seller.

Key People Necessary

You need to have someone knowledgeable about federal taxes and state and local taxes. In a larger company, it would probably be your head of tax and their team who would have that knowledge. 

So would also be hiring a third party to do your financial diligence, quality of earnings, and so on. And then part of that, you can negotiate to have a tax module as part of that. 

Sometimes it's done by your legal team. So as part of your legal due diligence, these kinds of things come up as well. So a combination of lawyers looking at it as well as finance slash stocks folks.  

Understanding Client Base

If you have a concentrated client base, you will have to understand how concentrated it is, and also how sticky are those software clients? 

Even though software tends to be relatively sticky because it takes a lot of time and effort to implement new software for your company, there can be various degrees of attachment to the founder and the current management team.

Those guys are at risk of leaving. Then you might have clients leave as well. 

So it's something that you want to diligence and usually, I like to do it right before signing, or maybe late in diligence. You might have client calls where you set up a time with important clients and talk to them about their relationship with the company. 

How happy are they? What are the issues? Just try to gauge how engaged they are and how likely they will continue with that product and with you as a company.

Customer Contracts

Customer Contracts are critical in software because most companies implementing a system are a very big effort, very big expenditure for them. So they tend to put a lot of those clauses in. 

So I want to make sure that if there are any changes of control where the customer has the right to consent or get out, I want to understand what those are.

You also have situations where some of the larger customers have even rights to buy a copy of the code on change of control. So this is something that can be very tricky for a deal. 

If you're buying a company, your target and your code are really the company's chief asset. And so if you have different versions of the code flying around, the customers having perpetual licenses on it, you have to make sure that you fully understand those types of issues.

IP Issues

In addition to the code audit, the clear title, and the open-source that I mentioned, I would also say that this other example that I mentioned about people selling different versions of the code to others may be floating out there. In some cases, it can prevent an M&A deal altogether. 

In that case, instead of an M&A deal, but you still want that capability for your business, you can maybe make a licensing arrangement instead. 

Accounting Issues

So the other thing I would also note is accounting. There's a relatively new, several-year-old accounting standard called SCS606, and that is a different way to stake your revenue. 

Many companies have already shifted to it over time. There have been some extensions because of COVID and for smaller companies and so on. 

So you have to make sure that somebody is giving your financials, especially at a very early stage, when you're just browsing, or you're just having the initial conversations that you are making sure that they are using the 606. If they're not, then you know how to restate that.

Seemingly it's just an accounting change, but visually it can have a big impact on people.

Advice For First-Timers

The most important thing is managing the expectations of your internal stakeholders and educating them about software M&A processes and, very importantly, software multiples. 

Other companies tend not to trade nearly as high in multiples as a software company with them. So it causes a sticker shock. 

When you go for approvals, folks say, you want to pay how much for this, and we're trading at this, and you want to pay that and make numbers work, making it creative can be challenging, though, in those situations. 

So I think it's doing that work with your M&A strategy with your executive decision-makers to prepare them for that agenda. 

How About Culture?

That's a good point. So that's usually something you would look at in every deal and definitely a big one with technology where often, you're buying a smaller company that has been operating very well as a smaller company. They've been able to do things. 

So let's say often, in a much more agile way, they're able to feed up and do stuff and run around without doing too much overhead and approvals. 

You're getting a bigger company to swallow them up. You might have approvals that have to be done for certain things. So it's definitely something you want to test out. 

I don't think that's a huge deal usually. I haven't seen deals failing for that reason. It's generally more of the hard things that I mentioned in the code,  the tax, the accounting, the other stuff. Cultural issues, I haven't seen cultural issues fail, but it's something you definitely want to understand, and it's a bit hard to test.