Growth Equity: 5 Diligence Questions to Ask a So-Called Software Company
Updated: Oct 19, 2020
For any Investor, the key to diligence is asking the right questions. If you're not satisfied with the answer you get, keep asking until you find either a satisfactory answer or the root of the problem.
Especially when it comes to funding, Founders can unfortunately be incentivized to embellish the truth and oversell themselves. Below are 5 easy questions you as an Investor can ask so-called software companies to assess product and business strength.
1) Can I see a product demo?
The product demo will give you the best picture of what the product does and what it does not do. It's easy to use buzz words to dance around the question of what the product actually does, but it's much harder to fake a product demo. A demo speaks a thousand words. In addition to a demo, ask the Founder to make you a trial account on the app so you can play around with it yourself. Many Investors do not ask for a full product demo until very late into diligence, but for me, this is one of the first things I want to see.
2) Please show me your organizational chart. How many people work in engineering?
A quick way to assess engineering horsepower is to see how many people actually work in Engineering. As a general rule of thumb, very early stage software companies should have 50% or more engineers. As the business scales, engineering headcount should still not dip below 35% of total employees.
3) Please show me the revenue breakdown in as much detail as possible on the historical financials.
Request to see the historical P&L and hone in on the revenue mix. Does the Company split software, services, and other revenue? A higher percentage of software revenue is almost always better.
For the revenue that is booked as software revenue, is it truly recurring? To determine this, you will either need to ask very pointed questions or read the B2B contracts themselves. If contractually the payment is structured as a take rate of sales or anything that is not a clear-cut subscription, that should not be considered recurring revenue. Revenue that is "reoccurring" should not be confused with recurring revenue.
4) Please show me 3 example customer contracts.
Read the B2B contracts. Does it say that the Company provides “software” or “services”? Then ask the question, at the end of the day, what value does the Company truly add to its customers? Beware of companies that primarily do custom software builds. These companies' P&Ls will rightfully show software revenue, but the real value add is that it builds applications for customers from scratch.
5) Do you have patents to protect the software? If so, please share the patent number and copies of the granted claims.
Reading the actual patents can be tedious, but it will tell you what the patent actually protects. You should also ask, has the patent ever been infringed by competitors, and has the Company legally enforced this? A patent is only as strong as its ability to protect the tech in a court of law.
You can probably ask Questions 1 and 2 before signing an NDA. Questions 3-5 will require executing an NDA.
Bonus: Do you capitalize software development costs?
Most software companies invest big money upfront into developing the product itself. The product is the entire Company and all of the future revenue opportunity. As such, many companies decide to capitalize these developments costs (mostly just engineering salaries) in order to flatten out expenses on the P&L. This is acceptable by GAAP standards, but you should ask upfront so that you can factor it into your internal model. Basically, this means that cash burn is much higher than the P&L would let on.
Valuation: Sum of the Parts. I think the best way to value a company with a mix of recurring and non-recurring revenue is to use the Sum of the Parts valuation methodology. I would give the non-recurring (services or other) revenue 2-4x, then add 8-15x the true recurring revenue. By adding these two components, you can reach a reasonable valuation.
General Rule of Thumb: Tell the Truth. To Founders, it is OK if you are not a software company, let alone not a technology company. There are customers and investors for all types of companies, so have faith that the right buyers will find the right sellers. I believe the best path to success is being clear about what you are and what you are not. The more truthful you are with customers and investors, the more they will trust you and be excited to work with you.
About the Author
Bonnie Young runs the Amplified blog. She shares her insights on market trends from US to Asia and interviews founders shaking up the tech scene. Please reach out to her at firstname.lastname@example.org with your questions and feedback. She is currently looking for a growth equity or VC role in the Bay Area.