Software Just Got More Expensive in California

How California's New SaaS Tax Could Reshape Technology Valuations

Beginning January 1, 2027, California will significantly expand its sales and use tax base by taxing various digital products, including prewritten software transferred electronically and Software-as-a-Service (SaaS). California historically excluded electronically delivered software and SaaS from sales tax. Senate Bill 122 creates new considerations for technology companies, investors and transaction professionals.

The new law represents California’s most significant expansion of its sales tax base for digital products in decades. As part of California’s 2026-2027 budget, the state estimates the change will contribute about $900 million to the general fund and raise $1.1 billion in local sales tax revenue annually (roughly $2 billion combined).

Much of the early discussion has focused on compliance. That framing understates the risk. A new variable now sits inside every California-based technology transaction. Operating costs, EBITDA and ultimately enterprise value are all exposed in ways historical financials have not captured.

This article outlines the new diligence and purchase price considerations sponsors evaluating California-based technology targets should understand before the next transaction closes.

A New Diligence Variable

The new law creates additional diligence considerations for buyers, including whether a target’s offerings fall within California’s expanded taxable digital products definition. Because the law applies prospectively, diligence should focus primarily on compliance readiness rather than historical SaaS exposure.

California continues to exempt certain electronically delivered services where the primary value consists of substantial human effort, while traditional SaaS offerings that primarily provide access to prewritten software will generally become taxable. However, for businesses offering AI-enabled solutions, managed services or other hybrid products, the distinction may not always be clear. As a result, product design, contractual language, invoicing practices and customer deliverables may all influence taxability.

For sponsors, diligence should include assessing how a target’s offerings are likely to be classified under the new rules and whether contracts, invoicing and product documentation appropriately support that classification. Targets that have not yet addressed these questions may carry undisclosed compliance and cost exposure heading into close.

Purchase Price Implications Beyond Compliance

One frequently overlooked implication is the law’s impact on California-based technology businesses as software purchasers. Organizations have historically acquired SaaS subscriptions, cloud infrastructure, cybersecurity platforms and other software solutions without incurring California sales tax. Once the new rules take effect, these purchases may become taxable, increasing operating expenses. In several California jurisdictions, combined sales tax rates can exceed 10%, making the impact particularly meaningful for businesses with significant software spend.

For private equity sponsors, this extends well beyond compliance. Historical EBITDA reflects a cost structure in which software expenditures were generally not subject to California sales tax. Those additional operating costs may reduce EBITDA unless mitigated through pricing or other operational efficiencies. Accordingly, even modest increases in operating expenses could meaningfully affect enterprise value. Investors should therefore consider whether projected financial performance appropriately reflects these changes when evaluating technology targets.