Understanding SaaS M&A Due Diligence
Tips to help anyone interested in buying an internet business.
Unlike physical inventory businesses, cloud-based software has created a rapid and profitable business model. As a result, private investment firms are searching for undervalued private companies with the goal of acquiring them and ultimately finding ways to add value.
Any investor looking to acquire a SaaS business must understand the key business drivers within the day-to-day operations.
Understanding these functions will help de-risk a valuation and allows both target and acquirer to attach the appropriate value to the right metric in order to establish an agreeable valuation.
Under the SaaS model, companies and investors can focus energy on improving the product and user experience. When done properly, this produces strong, consistent revenue growth while the recurring economics support faster scale and reduced risk.
According to Software Equity Group’s annual report, overall deal activity in 2018 reached an all-time high of 2,746 SaaS-focused M&A transactions, breaking the prior record set just last year.
Attractive future revenues, buyout potential and the declining costs to service customers as the company grows heightens M&A competitiveness in the SaaS ecosystem.
One of the main factors that makes SaaS sector unique is the level of knowledge required in order to maintain the application. Ideally, the acquirer should have some experience in software development, or be able to reliably outsource operations to a trusted developer.
Given SaaS valuations are largely pinned to Annual Recurring Revenue (ARR), churn stands as one of the most important indicators of company’s ability to sustain over time.
Churn represents the ultimate failure within a SaaS company: customers who tried a product and decided it wasn’t worth paying for.
Most SaaS businesses book revenues on a monthly basis. Each month their net monthly recurring revenue (MRR) gets determined by adding their new MRR and any expansion or add-on MRR from existing customers and subtracting out loss or “churned” revenues.
Churn approaches are varied and must be considered in relation to the overall business model.
Most consumer-facing SaaS companies are built on small, individual, month-to-month recurring contract so a classic customer churn rate is appropriate:
Customer Churn = Number of Churned Customers/Total Customers
Customer Churn Rate = (Customers beginning of month — Customers end of month) / Customers beginning of month
- 100 customers at the start of a month
- 5 of them cancel
- 5/100 = 5% customer churn
Alternatively, B2B SaaS businesses present a different pricing model where long term contracts and cancellation fees are standard.
Within most enterprise software solutions, such as software built for large teams or software that requires extended periods of time to onboard, companies typically require a 12 or 24 month customer contract.
In this scenario, churn is less of an impact metric and I would strongly advise the acquirer to focus on customer satisfaction/customer success data as an alternative anchor metric.
What is LTV:CAC Ratio?
To understand the marketing metric LTV to CAC ratio, you first need to break down the two components: Lifetime Value (LTV) and Customer Acquisition Cost (CAC).
Lifetime Value (LTV), referred to as customer lifetime value, is the average revenue a single customer is predicted to generate over the duration of their account.
LTV = Average monthly revenue per customer X (# months) customer lifetime
Customer Acquisition Cost (CAC) is the average expense of gaining a single customer.
CAC = Total sales and marketing expenses / (#) new customers acquired
The easiest method of calculating CAC is to add up all the expenses of acquiring a customer and divide it by the total number of new customers. Expenses include costs at every stage of the funnel, ie. marketing salaries, PPC campaigns, sales executives, etc.
Traditionally, a company had to engage in shotgun style advertising and find methods to track consumers through the decision-making process.
Today, many web-based companies can engage in highly targeted campaigns and track consumers as they progress from interested leads to long-lasting loyal customers. In this environment, the CAC metric is used by both companies and acquirers.
Source Code Review
SaaS businesses should have well-documented, annotated and tested source code. This is a must-have for investors looking at $500K+ Annual Recurring Revenue (ARR) businesses, particularly if they want to scale into seven figures and beyond.
A well prepared target (seller) will always have good documentation of their source code — if they don’t, it’s a bad sign.
Good documentation is characterized by:
- Readability. Is it simple and concise? How easy will it be for you (or your developers) to use?
- Transparency. Is there version control and numbering?
- Stability. What does the error log look like? How reliable is the code, and is it likely to cause downtime for the business?
- Trustworthiness. Does the code follow a set of guidelines? What standards were used when creating it?
In essence, code should be easily understood. This means it should be straightforward and not contain any superfluous touches. Having DRY code is key to an easy transfer.
Intellectual Property Review
Within the SaaS business model, securing IP is a must, especially for transactions that are expected to run above $1MM. In an ideal situation, a business owner would have pursued IP in the early stages of the business, though there generally aren’t any drawbacks to retroactively applying for trademark before the sale of the business.
This can be done through the United States Patent and Trademark Office, though you should be aware that trademarks tend to be easier and less expensive to obtain than patents.
Any programmer that was involved in developing the product should also sign an IP assignment for the work they have completed. This also applies to contractors, freelancers or third-party companies. Though this is most pertinent to sales larger than $1MM, it is worth securing IP at the outset of a business, regardless of its size.
In SaaS due diligence, evaluation of customer support needs to extend beyond simply acknowledging the existence of resources such as a ticketing system, knowledge base library or call center. In most cases a thorough audit of the customer support funnel will surface valuable data that will be useful in placing a value on the businesses ability to retain customers.
Customer support teams ensure customer success — that is, improving retention and capturing cross or up sell/expansion opportunities.
Each due diligence plan must be tailored to the specific circumstances of the target company. If a one-size-fits-all approach is employed, the acquirer runs a significant risk of doing too little (and exposing themselves to otherwise avoidable risk factors) or doing too much (and incurring more due diligence expenses than necessary).
Diligence teams need to focus their efforts around assessing the fundamental drivers of a businesses growth. Understanding the business model and critical levers that support the growth of a SaaS company put deal teams in a strong position for decision making.
Ultimately, this devalues the hype, limits overpayment and enables acquirers to extract real value from targets.