A software company can look like the cleanest deal on your list. There’s no inventory to count, no trucks to inspect, and the broker’s deck leads with a recurring revenue number that seems to grow on its own.
That recurring revenue is exactly why buyers love SaaS, and it’s also where most of the diligence risk hides. The number on the first page of the deck is usually built from a billing system, a spreadsheet, and a few assumptions, and none of those have been tested by anyone on your side yet.
Before Ashford Sky, Darin was the first tax hire at a SaaS company and built its tax function from scratch, so we’ve seen these books from the inside as well as from the buyer’s chair. These are the SaaS due diligence checks we run before someone closes on a software business.
What Makes SaaS Due Diligence Different From a Typical Small Business Deal?
SaaS due diligence is different because the value sits in future revenue the customer hasn’t fully paid for or received yet. With a landscaping company or a dental lab, you’re mostly confirming that last year’s profit happened. With software, you’re also confirming that next year’s revenue will show up.
That shifts the work. A normal small business review leans on the tax returns and the bank statements, and those still matter here. But a SaaS buyer also has to understand how revenue is billed, when it’s earned, how long customers stay, and what the company owes customers who paid upfront.
It also means the seller’s own reporting deserves a little more skepticism than usual. Most small software companies don’t have a controller, and the person who set up the billing system was often a developer solving a different problem. Nobody was trying to mislead you, but nobody was building the books for a buyer either.
ARR Has to Tie Back to Billing and the Bank
Annual recurring revenue (ARR) is a forecast dressed up as a fact, so the first job is tying it back to money that actually moved. We start where every deal starts, with a proof of cash that matches reported revenue to bank deposits month by month.
For most SaaS companies, Stripe or a similar processor is the right revenue source of truth. The catch is that Stripe is only as useful as its metadata. If the developers reused the same charge codes across different products, revenue segmentation is broken at the source, and no amount of cleanup later fixes that.
We see a version of this a lot. On one engagement, revenue had sat in the books as a single line item for years. When the company finally split it into categories, the categories were a starting point at best, and nobody trusted them enough to make decisions with them. Forecasting was a mix of spreadsheets, AI-assisted modeling, and gut feel.
None of that kills a deal. It just means the ARR in the deck is a claim, and you want the billing export, the processor reports, and the bank statements to tell the same story before you pay a multiple on it.
Deferred Revenue Is a Liability You Inherit, and Sometimes a Tax Asset
Deferred revenue is cash the seller collected for service they haven’t delivered yet, and when you buy the company, you inherit the job of delivering it. If customers prepaid for a year of software, you’ll be running the servers and answering support tickets for months after the seller has spent the money.
That makes deferred revenue one of the most underpriced items in a small software deal. It belongs in the working capital conversation, and it can reduce normalized earnings if the seller’s numbers count prepaid revenue as earned too early.
The tax side is more interesting than most buyers expect. On one software acquisition we worked on, the seller asked to be paid for the tax they owed on the deferred revenue the buyer was taking over. The buyer’s first reaction was that it sounded like a bad deal. It wasn’t. In that deal, the seller had already paid tax on that cash, and the way the deal was structured meant the buyer didn’t expect to owe tax on it again when it was recognized after close. That protection had real value, but the result depends on the deal structure and the seller’s tax accounting method, so it isn’t automatic.
We also told that buyer to keep receivables separate from deferred revenue, because the two raise different tax questions in a deal. How this works for you depends on how the deal is structured, so it’s worth having someone model it before you agree to anything in the seller’s workpaper.
How Do You Tell Real Retention From a Good-Looking Average?
You tell real retention apart by breaking customers into cohorts and watching each group over time, instead of trusting one blended churn rate. A single retention percentage can hide a lot, because strong new sales can paper over older customers quietly leaving.
Say you’re looking at a company whose ARR grew 20% last year. When you line customers up by the quarter they signed, you might find that the group from two years ago has lost a third of its revenue, and the growth is all coming from new logos. That’s a very different business from one where customers stay and expand.
Two metrics we’d add right away are the MRR and ARR trend month over month and revenue per salesperson. The trend shows whether growth is compounding or lumpy. Revenue per salesperson tells you whether the sales spend is efficient or whether the company is just adding headcount to chase a number. When the top line climbs and those two stay flat, growth is outpacing profitability somewhere.
Customer concentration matters just as much. If a handful of accounts make up a big share of revenue, you want to know their contract terms and renewal dates before you set a price.
Retention tells you whether the revenue will stay, but it says nothing about what the company owes on the revenue it already collected.
Sales Tax Exposure Follows the Software, Not the Office
Sales tax is the exposure software sellers most often don’t know they have. A SaaS company with one office and customers in every state can still owe collection in states where it has no employees and no address.
That’s because of the 2018 South Dakota v. Wayfair decision, which, as the Texas Comptroller explains, means states can now require sellers with an economic presence to collect tax even without a physical one. On top of that, states don’t agree on whether software subscriptions are taxable at all. New York, for example, taxes a license to remotely access prewritten software when the customer uses it in New York.
So the question in diligence isn’t only “did they file?” It’s which states the customers are in, whether the product is taxable in each one, and whether the seller ever registered. Small software companies often never did. Whether an unpaid balance follows you depends on the state and on whether you buy assets or stock, so we flag it, size it, and send the contract protection question to your attorney.
Stock Deals Bring the Seller’s Tax History With Them
If you buy the stock of a software company rather than its assets, you’re buying its tax history along with its code. One of the first things we ask for after any stock deal is the acquired entity’s prior-year tax returns, because that’s where carryovers and exposures show up that never made it into the letter of intent.
Skip that step, and you’re flying blind on the tax attributes you just paid for. We’ve also seen buyers get surprised after close when a lender or investor asks for audited financials. A financial statement audit includes the company’s income tax provision, and that work can take months, so it’s worth scoping with the auditors before anyone starts fieldwork rather than finding out mid-close.
In an asset deal, the paper trail is different but still matters. In most cases, the IRS requires both the seller and purchaser of a group of assets that make up a business to report the sale on Form 8594, so the price allocation you agree to will show up on both sides’ returns.
What Should a SaaS Quality of Earnings Adjust?
A SaaS quality of earnings should adjust reported earnings for anything that won’t repeat under your ownership and for revenue recognized in the wrong period. That usually means owner compensation, one-time costs, prepaid revenue counted as earned, and any contractors or tools the founder ran through the business personally.
Our quality of earnings report covers the same ground for every buyer: proof of cash, tax return reconciliation, add-backs, customer concentration, working capital, and management Q&A. For a software target, deferred revenue and the billing tie-out get extra attention, because that’s where SaaS earnings drift the furthest from what the deck says.
It’s worth saying that a QoE isn’t an audit. It’s a buyer-side look at whether the earnings are real and repeatable, and the scope should match the actual risk in the deal. A content site paid by advertisers in arrears has almost no deferred revenue to analyze, while a company that bills annual contracts upfront has plenty.
Buying a Software Company With Clean Numbers
This is general education, and every software deal has its own quirks in how it bills, recognizes revenue and handles tax. If you’re still building your process, our buy-side due diligence checklist for acquisition entrepreneurs covers the steps that apply to any target, software or not.
If you’re already running a SaaS company after close, our outsourced tax department for SaaS picks up where diligence leaves off, from sales tax to the next acquisition.
If you have a software company under letter of intent, book a call with us and we’ll walk through what the numbers need to show before you close.
Talk soon!
