Key Aspects of SAAS Revenue Recognition and M&A Due Diligence

Key Aspects of SAAS Revenue Recognition and M&A Due Diligence

November 16, 2022

Cloud-based software-as-a-service business models are enabling rapid growth in some of the most innovative software-service companies. As technology companies evolve to meet market needs, the accounting and financial services industry must also adapt to address investor needs for financial reporting, business valuation, M&A transaction due diligence, and dispute resolution.

Four of Stout’s service groups discussed the key aspects of SaaS revenue recognition. Steve Sahara, Director in Stout’s Disputes, Claims, and Investigations practice, interviewed Jeremy Krasner, Managing Director in the Valuation Advisory practice; Brad Burch, Managing Director in the Accounting and Reporting Advisory practice; Kevin Pierce, Managing Director in the Disputes, Claims, and Investigations practice; and Joe Randolph, Managing Director in the Financial Due Diligence practice of the Transaction Advisory group.

Steve Sahara: Can you describe the growth you have seen in SaaS businesses and how that impacts your business valuation practice?

Jeremy Krasner: The SaaS model provides customers with many benefits, and it has been a strong performer for investors. Certain SaaS businesses, or at least those with high revenue, have historically delivered revenue growth in excess of 30% but with cash flow margins of negative 20%, as well as significant research and development and sales and marketing expenditures. Over the past five years or so, the higher-revenue-growth companies were rewarded with higher valuation multiples despite the negative cash flow.

In addition to revenue growth, a valuation should consider other key metrics such as retention rates, customer acquisition costs, sales and operating efficiency, and the experience of the management team itself. Given the high growth and low (or negative) cash flows that are often projected for years to come, traditional valuation approaches can be challenging to apply. Selecting appropriate multiples and discount rates for discounting future cash flows requires a multitude of assumptions that can be challenging to support and/or highly subjective.

While growth remains a key valuation driver, having a clear line of sight to positive cash flow is even more important to investors now than during the past few years. Many clients—as well as the private equity and venture capital communities—are actively pivoting away from a “growth at all costs” strategy and scaling back a bit on expenditures to improve the cash flow margins and expectations for profitability.

Sahara: What are the crucial technical aspects of SaaS revenue recognition of which to be aware?

Brad Burch: Two big aspects stand out to me as especially relevant, the first of which is contract termination provisions. Termination provisions without cause at the option of the customer could cause the contract term for ASC 606 purposes to be shorter than the legal contract term. When payment terms are monthly, for example, and the customer can terminate the contract without cause upon written notice provided at the beginning of each month, the contract may be 12 separate one-month contracts as opposed to a single 12-month contract. This would result in determining the performance obligation and transaction price for the 12 separate contracts, which likely would result in a difference than if it had been a single contract of 12 months.

Second, pay attention to setup activities versus implementation services. Incorrectly concluding that setup activities are promised services or incorrectly concluding implementation services are setup activities could cause incorrect identification or performance obligations. Setup activities, which may include setting up the user interface, aren’t promised services and not a performance obligation under ASC 606. But implementation services, which may include data conversion and migration services, are generally promised services that should be evaluated under distinct criteria and may be separate performance obligations under ASC 606.

Sahara: What typically causes SaaS revenue recognition disputes between buyer, seller, and insurer?

Kevin Pierce: Post-mergers and acquisitions disputes regarding revenue recognition typically arise when the target company’s products and/or services require a more complex revenue recognition mechanism—for example, SaaS or percentage of completion. The more complex revenue recognition mechanisms will require increased judgment on the part of the company’s management. The more judgment required to recognize revenue, the more likely disputes are to arise between a buyer and a seller regarding the propriety of the target company’s revenue recognition. Typically, a buyer will contend that the seller prematurely recognized revenue that should have been deferred or delayed, resulting in an overstatement of the profitability of the target company prior to the acquisition transaction, which allegedly resulted in the buyer paying a higher price than it otherwise would have.

The SaaS delivery model created challenges in revenue recognition even before the adoption of ASC 606. SaaS arrangements can include multiple deliverables under one contract (configuration, training, data management, implementation, customization, expansion, add-ons, etc.) and may allow for renewals. ASC 606 requires a specific five-step process to identify when and what amount of revenue should be recognized.

Depending on the complexity of the SaaS contract, the application of that process may require significant judgment by management, which can impact the timing of revenue recognition associated with the delivery of services under the contract. As discussed previously, the more judgment required in revenue recognition, the higher the risk of differing interpretations between a buyer and seller, and the higher the potential for a dispute in a transaction.

Sahara: What should buyers be aware of regarding diligence for SaaS businesses?

Joe Randolph: While we still perform our standard analyses for all businesses, focused on quality of earnings, net working capital, and net debt, we typically focus more on quality of revenue and revenue metrics. SaaS businesses have a unique recurring revenue stream that buyers will want to get comfortable with. So while GAAP reporting is important in diligence, buyers of SaaS businesses often place an even greater emphasis on SaaS revenue metrics (generally based on billings/cash basis) that inform their business and operational assumptions. Customers’ monthly recurring revenue, how quickly customers churn (that is, who did not renew or recur in a given period), and the time to recover customer acquisition costs are key metrics that impact SaaS business cash flows.

Financial diligence providers often play a key role in helping clients assess monthly recurring revenue (MRR) and churn by performing retention analyses. In a retention analysis, we look at the number of customers and the monthly or annual recurring revenue associated with such customers based on billings. We can quickly get a view of the trends in recurring revenue, the volume of active customers, and revenue per customer. While MRR and annual recurring revenue (ARR) provide an understanding of the run rate of revenue for a particular business, it is only part of the equation that buyers should be concerned with. Churn and retention (customers who renewed or recurred in a given period) provide a view on the risk and volatility of a company’s customer base. A company with high churn, or low retention, requires more effort and more costs to maintain the current revenue. Conversely, a company with low churn, or high retention, is generally less volatile and is more attractive to buyers.

Reprinted with permission from Bloomberg Tax.