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All You Need to Know About SaaS Due Diligence

Saas Due Diligence
SaaS Due Diligence

Before starting our incredible journey of learning a SaaS due diligence process, we want you to know some fascinating facts about the SaaS industry. We sincerely hope you’ll be shocked after reading these stats.

Slack current worth is $5 billion, Salesforce market cap is $100 billion, and LinkedIn net worth is $26 billion.  The same trait amongst all these tech giants is that they are SaaS-based businesses. Unlike the traditional license software and brick-and-mortar shop, the SaaS business has experienced unprecedented growth in the last few years.

Investors love to invest in the businesses because:

  • It creates a recurring revenue model
  • It allows Widespread accessibility and cross-platform compatibility
  • It yields betta er returns than stocks, bonds, and commodities
  • Allow easy integrations with any other software or app due to add-ons and plugins in it.
  • Regular updates with no downtime
  • Collect user data and test new features consistently

Companies can emphasise improving the product in the SaaS business rather than wasting their time on useless things. If someone manages to develop a successful SaaS company, they can create a steady income stream without compromising their comfort.

Due to the phenomenal performance and unprecedented growth of SaaS startups, investors are willing to pay a premium price.

For instance,  BVP’s cloud index that includes 52 cloud-based Companies has yielded a 500% return since 2011. This number is four times higher than S&P500 and Dow Jones Industrial Average. 

Attractive future revenue growth, massive buyout potential, and a considerably low cost to service a user as the customer base expands boost SaaS Companies’ competitiveness. For this reason, SaaS Companies have experienced the highest merger and acquisitions in the recent past.

An investor who aims to acquire a growing SaaS Company should perform rigorous due diligence that tracks all the growth drivers of the SaaS business. 

Having a proper understanding of the SaaS due diligence process, an investor can significantly reduce the likelihood of overestimating a business. Hence, he can quote an accurate price for the SaaS Company without being inundated by the owner’s financial report and growth plans.

What is SaaS Due Diligence?

SaaS due diligence is the process that involves auditing or reviewing the performance of SaaS companies. From the finance standpoint, due diligence involves a comprehensive examination of all the financial records of the SaaS Company before acquiring it.

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The due diligence process rose into prominence after the passage Securities act of 1913 in the US. In this law, all companies, either a brick and mortar shop or a SaaS Company, are legally obliged to disclose all their financials and material information before diluting their equities or selling business.

The goal behind the enactment of this act is to offset the potential threat of any financial fraud. Moreover, writers of the act are aware that requiring the SaaS Company to disclose their complete financial track record prevents the potential investors from paying a high cost during M & M&A.

Which SaaS Metrics Matters Most During the SaaS Due Diligence?

As we all know that SaaS valuation is constrained to revenue growth, customer churn rate turns out to be a strong indicator of the company’s financial health. 

The churn rate indicates how many customers have tried the product and realised it isn’t worth spending money. All the SaaS companies are legally obliged to disclose their correct churn rate. 

Each month, the new MRR is calculated by adding the new MRR and any expansion or add-on from an existing customer and subtracting that from the customer churn.

Each aspect of the SaaS Company’s recurring revenue should be taken into account to assess a company’s financial health and future revenue growth. Perhaps no other metric tells a better story about the Companies performance than the churn rate.

During the SaaS due diligence process, the churn rate is given utmost importance because it shows the acceptance of the business model in the market. The higher the business model acceptance, the highest the churn rate.

A vast majority of the SaaS businesses rely on small, medium, and recurring contracts. Therefore, churn is a great metric to track here to identify whether the company’s revenue remains stable.

Use the following formula to determine the churn rate of any SaaS business.

Customer Churn = Number of churned customers/ Total number of customers a SaaS Company have at any given time.

Customer Churn Rate = (Total number of customers at the start of the month – total number of customers at the end of the month) / total number of customers at the beginning of the month.

Let’s say a SaaS Company has 250 customers at the start of the month; 10 of them cancel the subscription in the middle of the month, the churn rate will be 0.96%.  

It is worth mentioning that calculating churn rate has become so complex now. Studies show that publicly traded companies use 43 different methods to calculate churn rates.

On the other hand, some SaaS Companies rely on the B2B model, where a massive chunk of revenue comes from enterprise customers. 

As an investor evaluating a SaaS Company for M&A, revenue vs the churn rate provides an accurate picture of the company’s financial health. If the company follows a different pricing plan, revenue churn specifies how much customer cancellations are costing the company.

Using the following expression, you can calculate revenue churn easily 

Revenue churn = (MRR at start of the month – MRR at the end of the month) – MRR due to upgrades or expansions / MRR at the start of the month

Suppose that a company had $100,000 MRR at the start of the month, $50000 MRR at the end of the month, and earned $25000 MRR due to customers’ upgrades and expansions. Revenue churn rate would be:

(($100,000 – $50000) – $25000) / $100,000

= $25000 / $100,000

= 25%.

The example mentioned above suggests that a SaaS Company’s revenue churn is unsustainable. Cautiously speaking, investors are likely to underestimate retention concerns if they solely emphasise the revenue churn during the SaaS due diligence process.

Tomasz Tunguz, managing director of a VC firm Redpoint, describes this fact in these words:

“Churn rate varies by customer segment. SaaS Companies serving SMBs tend to have relatively higher churn rates ranging between 2.5% and 5%. This is because SMBs have the highest failure rate and unsteady revenue. In the mid-market, where revenue from an average customer lies between $10k to $250k, the churn rate will be 1% to 2%. Whereas SaaS Companies serving enterprise customers tend to have the lowest churn rate of 1%.”

As an investor willing to acquire a SaaS business, you should not overemphasise the retention figure. Although the customer retention figure indicates whether the customer remains loyal to the SaaS product, it doesn’t tell how much revenue a company earns from each customer. 

Likewise, although the retention figure indicates whether the customer is upgrading or downgrading subscription plans, it won’t tell whether the total number of customers is increasing or not.

What becomes an acceptable SaaS metric depends on the plethora of unique and appealing factors that are specific to the SaaS Company.

Understanding unique metric, particularly those mentioned above, allow acquirers to determine whether the company is earning money or not. It is an essential step for an appropriate valuation and assists in the due diligence process. 

Therefore, customer churn should be placed at the top of the SaaS due diligence checklist.

Importance of Unit Economics

In order to judge the commercial viability of the SaaS business, the acquirer first needs to evaluate can the SaaS Company earn more from a customer than it costs to acquire them? To figure out the answer to this question, you need to consider unit economics at the customer level.

In this regard, two essential valuation factors to account for are Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLTV).

Customer Acquisition Cost (CAC)

It is the quantitative measure of sales and marketing expense of a business to lure new customers into buying SaaS products. CAC is a strong indicator of business model viability. It tells the acquirer how much it costs to compensate for the customer churn.

CAC = Total cost incurred on sales and marketing / Number of customer companies acquired

For successful due diligence, the acquirers need to have a firm understanding of CAC. Otherwise, the acquirer will likely waste their money in a company that doesn’t have steady revenue.

By optimising CAC, a SaaS Company can significantly reduce its bleeding cost and start making money from its new customers immediately. It is cautious about mentioning here there is no universally accepted number for CAC.

Instead, an acquirer needs to have a solid understanding of the market SaaS Company is targeting and its competitive advantage. Besides, to extract meaningful insights from the CAC, an acquirer should consider the customer lifetime value (CLTV).

The industry-standard method to calculate customer lifetime value is:

Basic Customer Lifetime Value = Average Revenue per User (ARPU) * Gross Margin / Customer Churn

Let’s say a SaaS Company customer pays $1000 per month as subscription charges. The average gross margin of a SaaS company is 80%. The customer is likely to stick with the SaaS product for 36 months based on the past track record. Thus:

CLTC = $1000 * 80% * 36 = $28,800.

It is worth mentioning here to get a correct picture of CLTV, and it is pertinent to take into account gross margin. A successful and growing SaaS Company’s CLTV must be greater than its CAC. Otherwise, the company ends up burning too much cash.

CLTV is a crucial metric to track because it provides a more accurate picture of its financial health. For instance, ARPU only indicates how much a SaaS Company earns from each customer during a particular month or year.

However, this metric doesn’t tell how long a customer will keep paying and are they likely to stick with the SaaS product for an extended period. Moreover, for an accurate calculation of CLTC, a SaaS company needs to have a large customer base.

While evaluating the financial performance of a SaaS Company during the M&A, analyse a SaaS Company’s financial health and sustainability with the aid of CLTV/CAC ratio. It allows the acquirer to identify cash inflows and outflows into the company. Moreover, they can determine whether a company’s growth strategies have turned out to be fruitful.

Differences in SaaS Due Diligence 

SaaS diligence requires a cautious approach just because of the unique traits of the SaaS Company. SaaS industry expert FE international summarised the following peculiarities of the SaaS industry:

One of the main distinguishing factors of SaaS is the level of technical expertise required to lay down the foundation of SaaS products. Thus, we can say SaaS business founders should understand software development.

 Apart from that, SaaS business requires phenomenal customer support, so the business model is relatively less passive than the monetised website. During the SaaS due diligence, a solid understanding of the business’s customer base you are investing in is crucial. 

SaaS Companies are different from the traditional on-premise hosted software in many aspects. Understanding the factors that can affect the valuation of SaaS companies is crucial and must be taken into account before the commencement of the due diligence process.

Non-technical teams might not wholly appreciate the factor that can influence SaaS valuation. Here are a few areas that should be a critical part of SaaS due diligence and are often least emphasised.

Source Code Review

SaaS Due Diligence

A successful SaaS Company should have annotated, well-document, and nicely-formatted source code. It is quite evident from many examples that source code tends to influence a SaaS Company’s future revenue. 

A source code must be immaculate, efficient, transparent, and standardised for cloud-hosted software. It helps with a successful code transfer and creates room for further future growth.

Intellectual Property Rights Review

During the M&A due diligence, an acquirer is supposed to identify all the strengths and weaknesses of software. It includes what back-end technologies and databases are employed in technology production. Moreover, it ensures that SaaS companies can operate freely.

Besides, the deal team should thoroughly investigate all the third-party dependencies, including the open-source and proprietary tools and external libraries integrated into the SaaS product. This investigation aims to make sure all the dependencies comply with the licensing and royalty standards.

Apart from compliance assurance, the deal team should also ensure had the developers, technical staff, project managers, and system admin signed the IP agreement. By doing so, the deal team can minimise the chances of any possible litigation in the foreseeable future.

Customer Support

Due to the recurring revenue growth of the SaaS business, the customer support role is punitive to ensure growth and profitability. In a SaaS business model, customers have the freedom to stick with the product or switch to another one every month.

Thus, we can say SaaS Companies are selling themselves and their brand equity.

Amidst SaaS due diligence, customer support evaluation should not be limited to an assessment of the company available resources such as ticketing system, knowledge library, and call centre. 

Support teams ensure customer success, including maximising the customer retention rate and capitalising on all the upselling or expansion opportunities. 

The deal team should track essential metrics such as renewal rate, average response time, downgrade rates, and customer satisfaction score. 

Many SaaS Companies miserably fail here because all of their efforts are centric around expanding their customer score rather than increasing the satisfaction level of their existing customers. This situation is devastating for a cash-strapped SaaS Company because if they fail to satisfy their current customer, new customers are unlikely to purchase their subscription plan.

Conclusion

The scalability and profitability of the SaaS business urged many acquirers and investors to pay a premium price for this recurring revenue-generating business. However, an intelligent acquirer needs to be extra cautious while evaluating the critical growth indicators of the SaaS business.

Understanding the business and revenue model of SaaS Company along with the factors that can influence SaaS business growth should be included in a well-crafted merger and acquisition strategy. Eventually, the deal team can make a wise decision.

Lastly, this step clears out the unnecessary hype around the SaaS M&A, minimise the chances of overestimation of SaaS business, and allow acquirers to drive real value from their SaaS M&A targets.

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