Key Financial Due Diligence Considerations for SaaS Transactions

Financial due diligence is an important step in any mergers and acquisitions (M&A) process, helping buyers understand the risks and opportunities associated with a target company’s profitability and overall financial strength. Conducting financial due diligence for Software-as-a-Service (SaaS) companies presents specific challenges due to the unique nature of the subscription business model. The following represents the key areas of financial, accounting and taxation due diligence that prospective SaaS dealmakers should consider during a transaction.

Customer retention and churn: SaaS companies operate under a distinctive business model, centered around recurring revenue. Customer retention is key for investors as high retention indicates overall higher customer lifetime value, higher customer satisfaction and predictability of revenue. As such, investors place great emphasis on customer retention and churn rate (i.e., the rate at which customers stop utilizing the Company’s services over a period of time). Yet, retention analyses can be misleading if inputs or assumptions are not appropriately incorporated.

Common pitfalls include not appropriately understanding and considering customer contract terms (e.g., length, cancellation, etc.), overlooking downsells or upsells from existing customers and failing to segment customers into more meaningful cohorts based on different customer attributes. Higher retention rates may indicate a competitive advantage with more sustainable revenue streams and lower customer acquisition costs, which can lead to higher valuations.

Revenue recognition: ASC 606 mandates a five-step process to identify how and when revenue should be recognized. Given that SaaS contracts typically consist of multiple deliverables (e.g., access to the SaaS platform or software, implementation, customization, consulting, etc.), significant judgment may be necessary when applying the revenue standard, which impacts the timing of revenue recognition related to the individual performance obligations being fulfilled.

The unique characteristics of the SaaS delivery model can further compound the complexity. For example, in a 12-month contract with monthly customer billing and a termination clause allowing customers to cancel without cause at the start of each month, there may be subjectivity in determining the contract term, performance obligations, and transaction price for purposes of revenue recognition under the Generally Accepted Accounting Principles (GAAP; e.g., treating it as 12 one-month contracts vs. one 12-month contract). Additionally, it is not unusual for a SaaS company to have various offerings beyond cloud-based SaaS. For example, on-premise term licenses and perpetual licenses will both have distinct revenue recognition criteria that differ from true SaaS arrangements.

It is important to understand the nuances of a Company’s diverse service offerings and the implications for recognizing revenue. It is also important to understand the sales processes, as the use of distributors or other channel partners and related terms of a company’s contracts may have significant impacts on not only the timing, but also the amount and presentation, of revenues recognized.

Cash flows: While GAAP revenue is important, it may not consistently reflect the cash flows generated from sales, particularly for SaaS companies with substantial deferred revenue or unbilled receivables, as well as when up-front charges for services such as implementation and integration services are involved (which may be recognized up-front or may be recognized over a contract term or customer life depending on specific factors and circumstances). The timing of cash flows may also differ from GAAP recognition for costs to obtain the customer contract including, but not limited to, commissions.

In addition to considering GAAP revenue recognition, buyers should also consider the cash flows associated with the company’s core operations by evaluating the cash basis EBITDA or free cash flows, as this could provide a more accurate picture of its liquidity and financial strength.

Gross margin: Investors generally pay close attention to gross margin profiles in SaaS companies. Gross margin serves as a measure of risk management for investors, as SaaS companies with low gross margins may face challenges in generating sufficient profits to cover operating expenses. SaaS companies with high gross margins can efficiently scale operations to accommodate growing subscriber bases without incurring substantially higher operating costs.

Because gross margins provide investors with a benchmark to compare financial performance and gauge attractiveness relative to similar companies within the industry, it is important buyers fully understand the operational role of each employee (e.g., customer support/customer delivery vs. research and development, account management, etc.) and classification of their associated labor costs within the income statement.

Deferred revenue: Unlike transactions in other industries where deferred revenue is typically treated as debt-like on the purchase agreement, buyers and sellers sometimes include deferred revenue (both current and noncurrent) as part of net working capital, primarily due to the insignificant cost to service SaaS products. However, buyers should understand and consider the true costs to fulfill contract obligations post-close when determining the appropriate treatment of deferred revenue in a transaction.

If the true costs to fulfill future obligations are significant, then it may be in a buyer’s best interest to treat these costs as debt-like in the purchase agreement. Additionally, a buyer could be liable for paying taxes on income recognized post- transaction where the cash was received by the seller during the pre-closing period in a cash-free, debt-free transaction. Buyers should consider explicitly expressing how they wish to treat deferred revenue in their letter of intent to avoid potential disputes later in the process.

Deferred costs/sales commissions: Under ASC 340-40, deferred costs related to acquiring customer contracts, such as sales commissions, are generally capitalized and subsequently amortized in accordance with the transfer of the goods or services to the customer. This could result in significant variances between GAAP and cash expenses, similar to the impact of deferred revenue on GAAP revenue and cash flow. Buyers of SaaS companies may find it beneficial to evaluate EBITDA on a billings or cash basis and adjust for these deferred costs. Additionally, buyers and sellers should make sure the purchase agreement appropriately and consistently addresses the economics of deferred revenue and the associated capitalized contract costs.

Capitalized internal labor: Labor costs related to software development are capitalizable under GAAP, subject to specific criteria. However, these costs are more operational in nature representing the ongoing cost structure of the business, particularly for costs related to internal labor, which generally entail more effort and expenses to terminate compared to external contractors. Buyers should thoroughly understand the target’s capitalization policies, including the nature of the costs being capitalized and the breakdown between internal and external costs. Additionally, buyers should ensure that ongoing capitalized labor costs are reflected in their financial models.

Tax considerations: Rapidly scaling SaaS companies often face hidden tax complexities that can surface during mergers and acquisitions. One crucial area is sales tax. Historically, sales tax filing obligations, or “nexus,” was primarily driven by physical presence in a state. The Wayfair v. South Dakota ruling in 2018 expanded “nexus” beyond physical presence, meaning companies exceeding specific revenue thresholds in a state must register and collect sales tax, even without a physical presence in the state.

Additionally, state-specific tax rules add complexity when classifying a company’s offerings and assessing tax obligations. For example, one state might classify a SaaS offering as a nontaxable service, while another state may explicitly designate SaaS as a taxable enumerated service. In contrast, some states might take an indirect approach by modifying legal definitions to include SaaS offerings within other existing taxable services, such as data processing services. This is where expert guidance becomes crucial to avoid costly surprises.

Additionally, an expanded nexus profile for sales tax can lead to similar obligations for income tax and the possibility of target misclassifying internal labor as contractors to mitigate increased payroll costs.

To learn more about how due diligence can and help buyers or sellers avoid the potential pitfalls and issues that are common in SaaS transactions, contact Weaver today.

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