Due diligence in IT channel deals – what the seller doesn’t want you to know An article by Iain Campbell

Introduction

In a couple of posts earlier his week, I referenced the Autonomy/Mike Lynch trial in the US in which the allegations of wire fraud centre around the alleged use of so-called “round-trip pricing” to inflate the apparent financial performance and valuation of Autonomy and allegedly dupe Hewlett-Packard into overpaying (by HP’s calculation) €8.8bn for Autonomy. Here in the UK, there is extensive private equity ownership in software publishing and in the IT channel, and despite a slowdown in overall M&A market activity, the sector still seems to be attracting keen PE interest. If an IT industry behemoth like HP can get its acquisition due diligence so disastrously wrong, how can a PE house – that may have only limited existing IT channel investment, not necessarily in closely-aligned businesses, or be a first time entrant – be expected to be alive to the possible presence of some of the nefarious practices that do still go on in the IT industry and identify them and assess them in due diligence? Well, the commercially beneficial response to that for me is that you should employ an experienced, specialist software/IT channel advisory firm like mine to design and implement your due diligence programme for you (and do check that your proposed adviser really does have that first-rate experience not just as a firm but for the people who will actually do the work). However, if you are interested, and if you can spare the time for a longer read, maybe over the holiday weekend, I will take you through some of the issues you should be looking for, particularly as a PE acquirer or investor, in your due diligence on an IT vendor or IT channel business.

Potential loss of vendor or customer relationships

Whilst the value of a vendor is driven by the quality of its products (be those hardware or software) and intellectual property, the value of a channel business is driven by its relationships with vendors and customers. Particularly at the SME end of the market and certainly into the lower end of the multi-million pound EBITDA businesses that are typically entry-level for PE interest, I have often found that there can be significant, even extreme concentration of business around a single, or sometimes two or three, vendors or customers. In such a case, there is an inherent risk in the acquisition target business of loss of one or more of these relationships or, I would say statistically more likely, imposed changes to the terms of key relationships, that would bring about a material, sometimes fundamental adverse change to the target company’s financial performance.

There could be various reasons why a vendor/customer might end a relationship with an IT channel partner or impose changes to the trading terms, for example:

·???????? A change of ownership in the vendor or customer. This is particularly the case if the buyer is a PE house. For those of us who have worked in the IT channel, it’s pretty hard to explain to outsiders what the channel is and why it even exists. It’s even harder to explain to PE investors why vendors should choose to alienate margin in favour of the channel. As a result, PE investors in IT vendors usually have an irresistible urge to find out for themselves what happens when you try to be a “disruptor”. The result will be major change – anything from taking distribution and fulfilment in-house to gratuitously reducing channel margin. Whilst such changes are often fully or partially reversed later, the effect in the meantime on channel partners can be very significant, perhaps catastrophic, particularly if there is excessive dependence on the vendor/customer concerned. ??

·???????? Personnel changes in the vendor/customer or in the target company. New people might want to do things differently or, more simply, might not like the target’s founder(s)/management or may have negative perceptions about them based on experience or their industry reputation;

·???????? A distributor or reseller’s CEO and/or management may have been caught by a vendor or customer indulging in some of the nefarious industry practices of the type I am going to come onto, or at least be suspected of, or have a reputation for, such practices.

It follows that the buyer of an IT channel business will want to check in its due diligence process that all the key vendor/customer relationships that are in place at completion operate on terms that are fully understood and that the buyer is fully aware of and can quantify any risk of loss of such relationships or material change to their terms. My experience is actually doing this in DD is almost always a problem area. The sellers of a channel business will typically be implacably opposed to allowing the buyer any access at all to its vendors or customers before the deal completes, and there are obvious and perfectly legitimate reasons why the sellers would take that position. Any process that excludes direct access to key vendors and customers will by nature be sub-optimal, but the sort of things I would do would be to:

·???????? Look for sharp practices and unethical behaviour in the target company, particularly by founders/CEO’s and key management, that if they came to light could prejudice key relationship. (Again, I am coming on to specific examples – I promise.)

·???????? Check google, the press, analyst coverage and M&A databases for recent changes of ownership of key vendors/customers or speculation about potential changes of ownership. Take particular note if there is PE involvement.

·???????? Check for recent key management changes or speculation about potential changes of management in key vendors/customers. If there are any, investigate any history between the incoming management and the management/ownership of the target.

·???????? If the target is a distributor, check if any of its key vendors have made any recent announcements about appointing new or replacement distributors in territories where the target is or is understood to be a distributor, particularly if it’s a sole distributorship.

·???????? If the sellers allow you to, speak in person the target’s key vendor and customer accounts management. (You can always say you are an auditor or are reviewing risk management without having to say anything that isn’t strictly true.) ???

·???????? Cover off the (likely significant) residual risk by making sure you have a robust set of warranties that require any potential issues or threats to key relationships known to the target’s management to be disclosed., and require that all recent correspondence, e-mails and meeting notes between key target personnel and key vendor/customer relationship personnel are put in the data room and document bundle and are warranted to be a complete disclosure.

Software publishing revenue

Software publishing is an industry where gross profits are extraordinarily high. A very large proportion of a publisher’s costs relate to the development and maintenance of the software itself and those costs are effectively in the nature of fixed overhead (however they may be categorised in the accounts). By contrast, the marginal cost of making a software sale, particularly if it is generated or fulfilled via the channel, can be very low. This means that profitability is extraordinarily sensitive to sales volume. (I will ignore for now how publishing revenue is recognised over multiple accounting periods – that’s for another day.) As a result, simply because it pays so much in terms of financial performance, there is a pervasive culture in the software industry around using artificial mechanisms to overstate revenue or pull revenue forward across year-ends and quarter-ends. That culture then filters down from the software publishers through the other layers in the channel. It’s normally the case that sales staff and some other management and staff in the software industry and its channels are highly incentivised and can earn exceptional remuneration for hitting sales targets in particular periods. This has led to all sorts of at best shady practices designed to anticipate revenue, sometimes even to manufacture revenue, that for me, as someone who came to the channel relatively late in my career, are beyond anything I’ve seen in other industries.

In the listed company arena, in addition to revenue maximisation, there is also a focus on cash conversion as measured by data in annual and (sometimes) quarterly published accounts or results. I have seen so much bad practice in terms of resellers paying their suppliers a few days late at year end or quarter end or vendors demanding payment a few days early at year end or quarter end, sometimes in return for financial incentives and sometimes under threat of withdrawal of business. Doing this intentionally distorts the underlying cash position of the reporting business for just those few days of the year on which the entity reports and for me that looks a lot like false accounting. (What other reason is there for doing it? If it walks like a duck and quacks like a duck…) Channel partners who co-operate with or enable these practices for me are conspirators. Everyone knows what is going in and why. Chief Financial Officers should be calling it out and explaining in writing to CFO’s/boards/owners that it’s not acceptable. Auditors should be doing more too. For me, it’s not enough that the accounts show the actual cash position as per the ledgers at the year-end/quarter end. If cash balances have been manipulated to misrepresent the underlying position it’s not true and fair.

A big problem with manipulating period-end performance (whether revenue or cash) through interfering with the proper time-period allocation of transactions is that you have to do at least the same again at the end of the next period just to stand still. If you want to keep benefitting from the same trick again then you have to do it even more next period then even more the following period. The departure from reality gets greater and greater and eventually it will all fall down - someone will notice or will have to do something or there will be an insolvency. Unless, of course, you manage to sell your company to someone who doesn’t do basic due diligence properly.

Round-trip pricing? ?

“Round-trip pricing” as I say above is the issue reported to be at the heart of the Autonomy case. It involves the software publisher making a sale, say, to a distie, at ludicrously inflated pricing, perhaps way higher than the end-user sale value of the product. The distie then sells the product to a reseller for the actual wholesale value of the product and incurs what looks at first sight to be a substantial loss. However, the publisher at a later date (no doubt in a future reporting period) issues a credit note that reimburses the distie for the loss plus a distie margin (usually small relative to the underlying value). Because of all the irregularity, and a bit like MDF (which I shall come onto), normal ledger accounting that could for financial control and audit purposes be reconciled as between the publisher’s sales ledger and the distie’s purchase ledger doesn’t apply and quite likely the two parties account for the transactions differently so profit is magicked from thin air. ?

Consider this fictional example:

·???????? Distie sells a certain piece of software to its reseller customers for ￡50 per copy.

·???????? Distie is to make a 10% margin therefore the net price it agrees it is going to pay to publisher is ￡45 per copy.

·???????? However, publisher actually invoices the distie ￡100 per copy as and when the product is shipped and the distie accepts the invoices.

·???????? Later, in a different reporting period, the supplier issues a credit note for ￡55 to reduce the effective net price paid by the distie to the ￡45 net that was agreed.

In their accounts:

·???????? The distie recognises a ￡100 (ignoring VAT) liability in its purchase ledger but books a ￡55 prepayment at the same time, recognising that the nature of the arrangement is that the credit note is always going to be issued subsequently, which can be demonstrated has always happened in the past and it’s clearly key to what would otherwise be a nonsensical arrangement.

·???????? The publisher books ￡100 of revenue but doesn’t provide for the ￡55 credit note in that same period because it argues there is some theoretical possibility that, due to whatever bogus conditionality has been put in the terms and conditions, the credit note might not be issued later. Despite the fact that it is obvious from the transaction history that the credit is invariably issued later, the publisher’s auditors sign off on the treatment.

Thus the publisher, enabled by the distie’s full-knowledge co-operation, manufactures an extra ￡55 fictitious profit on a sale that only had a true ex-works value of ￡45 in the first place. One might ask why the distie in this example would agree to participate in this type of arrangement which is so obviously uncommercial and clearly intended to enable deliberate mis-reporting of the publisher’s financial performance. The answer is that there are some unscrupulous people out there in disties who will happily do so in order to secure a perceived lucrative distribution contract from a high-volume vendor and/or return for a bit extra on the margin. ????

As I said in my recent article about the Autonomy case, If a company is operating or enabling “round-trip” pricing and there is no credible commercial logic for it, and it’s just manipulation of financial performance, then the CFO needs to tell the board (or the owner(s) if it’s a private company) that it’s highly improper and not acceptable, and they should do so in writing and keep a record. That way, when it comes to giving witness evidence in any court proceedings that follow, it’s clear.

You would have thought it unbelievable that national and international audit firms would ever sign off on accounts that have been manipulated though round-trip pricing, but clearly this has not always been the case. If you acquire a software publisher/hardware vendor or a channel partner then it will in any case be your risk to assess. What the buyer should be doing in due diligence is:

·???????? Looking at revenue recognition/cost of sales recognition and credit note accounting policies and practices;

·???????? Looking at credit note volumes and amounts relative to overall transaction volumes and amounts between the parties to see if they make sense and/or are unusual;

·???????? Analytical review, eg ratio of sales invoice credits to customer turnover or ratio of purchase invoice credits to customer cost of sales; and

·???????? Making sure there are specific, robust warranties in the share purchase agreement that cover unusual and/or improper pricing and billing arrangements.

The risks if you get it wrong include:

·???????? The buyer of a software publisher misunderstands underlying financial performance of the target and pays far too much (as is alleged happened to HP with Autonomy);

·???????? If your acquisition target is the distie “enabler”, the software publisher gets bought out, then, when the buyer finds out what’s been going on, it terminates the distie’s distribution contract and sues it for your complicity in the overstatement of financial performance;

·???????? Word gets around in the industry about what the publisher and the distie have been doing and both suffer serious reputational damage and loss of business.?

MDF and overriders

“MDF” or marketing development fund is an industry feature that presents particular financial control and, therefore, due diligence risks in the IT channel industry. Its cousin, the overrider/retrospective discount, is more common across a range of industries but presents similar challenges.

MDF is a fund of money that a software publisher or hardware vendor makes available to downstream channel partners to promote its products. Overriders are discounts that are not given on invoice at the point of sale but are issued retrospectively. The problem with both of these concepts is that they exist outside of the normal arrangements for ledger accounting. What I mean by that is that if there were no MDF or overriders, the vendor would issue and book a sales invoice, the distie would receive the invoice and book it as a purchase invoice, the two would agree so both parties account for the transaction in the same way. In an audit or due diligence exercise, or just as a periodic financial control exercise in a well-run finance department, you can do a reconciliation to check that the balances agree in the books of both parties and investigate any differences. MDF and retro discounts are more like slush funds that typically get accrued and paid outside the ledgers, so there’s no invoice and there may be no means to check what a payment really for and that both parties have accounted for it the same. This makes MDF and retro discounts open to abuse. In the IT channel they do get abused and if you are buying a business you need to know this and look out for it. ??

The sort of thing that can easily happen without there being an obvious record include:

·???????? Unscrupulous management of a distie take MDF funding from a software publisher to fund an agreed programme of marketing events and activity but only a fraction of the funds are actually spent on the programme or, in extreme cases, nothing is spent at all. The distie then takes some or all of the MDF to profit and (if needs be) lies to the publisher about how the MDF has been spent. Then – unbelievable, but it happens – the publisher doesn’t bother to check whether the events or marketing activity took place and/or how much it cost.

·???????? MDF is used to fund bogus or inflated sales, or to accelerate/anticipate sales or orders usually at year-end or quarter-end, ie the vendor persuades the distie to take product it doesn’t want (or doesn’t want yet) through the ledger and rebates the cost off the ledger with MDF or retro discount.

·???????? Really bad, but it can happen, MDF is paid by the vendor to the distie on the condition that some of it is used to provide benefits personally to the vendor’s personnel.

These types of practices aren’t just a bit sharp, they can constitute fraud or false accounting. For me, if you find they have been undertaken or enabled by your acquisition target then you should walk away. If you don’t, then apart from possible criminal liability and serious reputational damage, you open yourself to the consequences when it all eventually comes out. If the target is a distie then, again quite possibly as a result of the publisher/vendor being taken over, the distie will likely lose the distribution contract and quite possibly be sued by the new owners of the publisher/vendor.

In due diligence, an acquiror should:

·???????? Look at what agreements there are for MDF and retro discounts and reconcile these to what is actually paid;

·???????? Check the accounting for these funds and what they are actually used for. This will involve checking invoices and other documentation and, possibly, checking the source of the documents to ensure they are genuine;

·???????? If the target is a distie or reseller, check what the publisher/vendor expected the funds to be spent on or thought the funds had been spent on. If there’s no clear documentation of this, get the target’s management to request it from the publisher/vendor or do it yourself (though your DD adviser) under the guise of an audit;

·???????? Reconcile MDF that has been drawn down to MDF spent. If there’s a shortfall, check whether it’s being held in reserve to be spent later (ie booked as an accrual or deferred revenue) or misappropriated and taken to profit.

Pass-through pricing

This one applies to distributors and resellers. If a distie or reseller is of any size, it is likely to have at least some customer contracts where the pricing arrangement is cost plus an agreed margin. Sometimes this can be very formal, in a written contract, with an auditing mechanism, and sometimes it can be just an informal understanding, or it can be anywhere in-between. Unscrupulous management in a distie or reseller may fail to honour the arrangement either blatantly or through manipulating data. This may go undetected through the customer simply assuming the agreement is being honoured, and failing to check, or as a result of mis-reporting or falsification of documentation. When it eventually comes out there may be a substantial back-dated claim, and/or the customer will be lost, and likely there will be significant reputational damage.

In due diligence, the buyer should be asking how pricing is determined on key accounts and asking to see documentation from customers that refers to it. Key customer contracts should be reviewed, and if there is a pricing formula or mechanism, transactions should be sampled to determine whether it is being adhered to. Analytical review should be performed comparing the margin on key customers, and if they are materially different, explanations as to why this is the case should be sought and verified. In the share purchase documentation, the buyer should take general warranties about non-standard pricing and specific disclosure of and warranties about pass-through pricing arrangements. ??

Demonstration copies of software

The contracts that distributors and resellers have with software publishers typically allow them to have free use of the software for promotional, demonstration and training purposes, sometimes for providing support too. Sometimes there is a fixed number of copies or installation keys and sometimes there is a right to make and install unlimited copies, but only for the specified purpose. But what if the distie or reseller wants to use the free software more generally in its business, which may well involve the distribution or resale of products that are competitive? This does go on. If management of the distie or reseller are unscrupulous, they will find it very hard to resist the temptation.

The risks for the buyer of such a distie or reseller once again are perhaps losing a valuable distribution contract and, maybe, a backdated bill, plus associated reputational damage. Worse still, there could be the dreaded letter from the British Software Alliance starting a process that could suck in the buyer’s other group companies or investees.

Counterfeit software

This one’s quite simple really. Some unscrupulous owner/CEO’s in disties and resellers sell as genuine product software that they know to be counterfeit, suspect may be counterfeit or are careless or reckless as to whether it is genuine or not. As software delivered via physical media dies out, this one is doubtless diminishing in importance, but if there is still physical product in the stack, this potential issue still needs to be checked. Software sourced from non-mainstream countries outside the UK and EU and pricing that looks too good to be true are obvious red flags that require investigation and explanation.

Research and development allowances and tax credits

The UK tax regime incorporates a system of enhanced tax deductions and tax credits for research and development expenditure. There are detailed and (on paper) highly demanding rules that set a very high bar for what type of expenditure qualifies. It is well known that this system was historically open to abuse, by no means just by software and IT channel businesses, and changes were introduced last year to the system that, if properly policed, will make it much harder for companies to indulge in such abuse in the future.

Prior to last year, it was open to a company to include a spurious deduction for R&D in its tax return and wait (in simple terms) a year to see if HMRC would query it. If HMRC didn’t, then the “inquiry window” closed and, subject to certain exceptions, the company’s tax position for that year became finalised. Given that it's widely believed that HMRC only ever checked about 1% of R&D deductions, the temptation to get away with it was too much for the unscrupulous and lots of claims were made for stuff that came nowhere near meeting the demanding technical definition of R&D expenditure and/or were simply based on lies about what the money was spent on, what outcomes were achieved and, in the case of staff costs, what staff were spending what proportion of their time on the relevant project(s). In this respect it should be noted that there is a common misconception that software development activity always fully meets the test of being R&D. That’s not the case at all.

Even if an “inquiry window” has closed, HMRC can in certain circumstances, particularly if there has been intentional wrongdoing, re-open tax returns and go back up to 20 years to collect underpaid tax, possibly with interest and penalties. Whilst such liabilities in an acquisition target may remain with the sellers through the terms of a standard tax covenant in share purchase agreements, that is not a guarantee that the full costs of an R&D tax investigation will be covered. Nor does it address the possible reputational damage to the buyer and possible contagion through the spread of a tax investigation into other group companies.

In its due diligence programme, a buyer should look at historic tax computations to see if there have been R&D claims and, if there are, rigorously assess their validity. Be careful here – a well-advised seller might have stopped making dodgy R&D claims in anticipation of an intended sale process so you might have to go back a few years. If there have been claims, assess their merits and the tax and reputational risk. If you find R&D claims that are so spurious and/or padded that they are basically fraudulent in nature, you might want to ask yourself what else might have been going on and choose to dodge a possible bullet by pulling out of the acquisition.

Conclusion

There’s quite a lot of stuff in this article I know, but believe me there’s more I could have included, and all of it’s just what I think is particularly relevant to IT channel businesses. All the general due diligence stuff applies equally to IT channel businesses the same as to other businesses – what’s the management like, who has really been responsible for the success, is there any succession, where is the company in its market and growth journey, etc. All of this goes to show that if you are making a sizeable IT channel business acquisition, particularly if you are a private equity buyer/investor (rather than closely-aligned trade buyer), you need a properly and insightfully planned and executed due diligence programme and you very likely need specialist, sector-specific advice. ???

?If you would like to explore any aspects further, please get in touch.

FC Corporate Finance Limited

Iain Campbell (Director) – email [email protected]

FC?Corporate Finance Limited is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Institute of Chartered Accountants of Scotland. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.