Identifying Risks in Software M&A

Software deals can be challenging, due to the complex nature of creating well-structured, and secure software. There are many nuances to consider in a software deal, and if you are not familiar with them, it can result in critical issues and lost deal value. Aside from the technical stuff that you need to learn, there are also key differences in a software deal that you wouldn’t normally have in a non-software acquisition. 

Sharing her expertise about identifying risks in a software deal in M&A is Elena Sidelnikova, Corporate Development Executive with 15 years of experience in M&A finance. She has M&A deal experience in software, healthcare, financial services and infrastructure. 

“One of the most critical pieces is making sure that the management team is motivated to join your company because of that knowledge base about that (software) code.” -  Elena Sidelnikova

Starting with technical due diligence, the first thing that you need to focus on software deals is the code audit and cyber securities. 

Code Audit 

A code audit is focused on checking the quality of the code. Make sure that the source is well written and scalable so you can add more clients and users as you apply the software to a much bigger company. Also make sure that the code is well-documented, so in the event that the people who wrote the code leave, you are still able to trace the code and make changes.

The second thing that you need to look for in a code audit is open-source site issues. You need  to make sure that none of the code, or at least, not a large portion of the code, is sourced from open source resources. This is extremely important because if the software that you're buying incorporates open-source code into their program, the law might require you to share the software out in the public. Then you would not have clear ownership of the software. 

Cyber Security

In software deals, the security of the software is extremely important. You need to torture test the security of the software and have a designated team focus on identifying security gaps and vulnerability in the software so you can improve on it. 

Foreign Talent

The software industry is no stranger to acquiring foreign talent, which is why you need to properly manage any employees who require visas. Make sure that every employee has proper documentation and permits to be working in your country so you avoid any problems with the law. Also, if you are doing an asset purchase deal, you will have to terminate the employees and hire them again as the new company. That can cause issues if you haven’t done the paperwork for that person to be transferred or if the employees are on visas, their visas need to be adjusted.

Retaining Key People 

Retaining key people is important in software deals because of the knowledge base about the code. So you need to have retention strategies to keep them happy, motivated, and excited to join your company. 

Taxes

Tax can be a huge factor when it comes to these types of deals. Make sure that the company has been filing their taxes the right way, otherwise, those liabilities can follow you around. There are also a lot of state and local taxes involving software companies. If you are a large company, your head of tax should be able to discover these risks. In many cases, this should be a part of your financial diligence and sometimes done by your legal team. 

Client Base

While software clients tend to be loyal, because it takes a lot of time and effort to implement new systems in a company, it is still important to gauge how loyal they are to the company. You can do this by having your relationship manager call the clients and ask questions about their satisfaction regarding the software. 

Intellectual Property

You need to find out how many people have access or rights to the code that you are buying. In some cases, your target company may have already sold copies of the code to other people. It might even be a good idea to just settle for a licensing agreement.   

Accounting

There is an accounting standard called SCS606 that can impact the way you look at the deal. Many companies have already shifted to it over time, but you need to check if your target company is using this kind of accounting. This will change the multiples of the company and will make EBITDA and the entire company appear a lot smaller on paper. 

Conclusion

There are many things to consider when you are doing software deals in M&A. You need to be fully aware of them in order to realize the full value of what you are buying.  Each one of the risks discussed above can cost you a massive amount of money, and in some cases, legal issues. Follow this guide and get the best outcome for your deal.