Unprepared for SaaS Due Diligence?

By Justin Talerico

Jul 05 2019

Many SaaS companies go through due diligence in a less-than-ideal state. That’s a lot less stressful when you know what that means.

A while back I wrote about what to expect in SaaS due diligence and provided an interactive institutional readiness report cardto help you prepare, but today I want to address the consequences of being unprepared for SaaS due diligence. Founders find themselves in diligence situations feeling unprepared all the time. Could be with a bank for a line of credit. Might be for venture debt. Could be for investment. Perhaps for an exit or partial liquidity event. Or could just be for an annual audit. Diligence is pretty common and universally painful. How painful? That depends on preparedness. Today, I want to look at what it means to you and your process if you go into diligence unprepared. Punchline: It’s not the end of the world. But it’s going to cost you time, resources, and money.

What is SaaS diligence?

It’s strangers going through your closets and hampers looking at your underwear. In SaaS, due diligence processes look at many things at a high level and certain things at a deep and specific level. For more on this look back at my articles on what to expectand how to prepare to be acquired. From a pragmatic perspective, SaaS due diligence is similar to an audit where they take samples of everything and drill into those things where the samples don’t true up. So let’s take the position that some important samples like churn, revenue or COGS don’t true up. That’s what we mean by being unprepared for SaaS due diligence. But what does thatmean to the deal?

What is being unpreparedfor SaaS diligence?

Let’s start with the less painful stuff.

There are many ways you can be unprepared for SaaS due diligence. Contracts could be undocumented. There could be unknown liability or legal exposure. Employee records or policies could be incomplete. And so on. Many things like that do have consequences, but they’re contractual reps and warranties more than they are valuation killers. So in a way, they’re less painful. (Still stressful.)

Reps and warranties are essentially risk mitigators that get written into your contract with the buyer or investor. Anything they’re uncomfortable with, or unsure of, will likely end up in reps and warranties for you to sign off on as your responsibility, not theirs. There are many flavors of reps & warranties — some longer term, some shorter. Some with potentially harsh financial and legal consequences and some not so much.

The more buttoned up you are, the fewer anomalous reps and warranties will be in your contract, and the less stressed you will be to negotiate them out or sign off on them.

The top (or bottom) three ways to be unprepared for SaaS due diligence

There are real, painful consequences that impact the process and financial outcome. These consequences come to be when important SaaS due diligence items are unprepared. My top three ways to get yourself into this super-hot water are revenue, churn, and COGS. There are others, but the consequences are similar, so I’ll just focus on these three.

Consequences of being unprepared in SaaS revenue booking

Revenue accuracy directly drives valuation. In SaaS, you’re likely getting an IOI or LOI based on a multiple of your top line revenue. So if validation of your revenue doesn’t match your stated revenue, your valuation takes a discount. And, if there’s something fundamentally broken in how you have booked revenue — for example you’re showing $3M/month in MRR but really only a million of that is recurring — your deal is likely dead in the water because you’re not what they thought you were.

But the far more common scenario is that some of your revenue is weak. This is why many SaaS companies pay the piper and send their financials through a quality of earnings (QOE) study prior to any third-party diligence. A QOE can find your weaknesses so you can shore them up before a third party finds them. But again, this is about consequences, so let’s say you either didn’t go through a QOE or you couldn’t fix what was found in your QOE.

SaaS valuation weak revenue discount factors

Weak revenue results in valuation discounts. It’s that simple. Aggressiveness in the discounting will depend on:

  • How muchthey want to do the deal — if the big-picture, strategic value far outweighs the potholes, they’ll be forgiven
  • How bothered they reallyare by the revenue weaknesses — Is it bookkeeping or is it actually impacting the business value?
  • How deepthey think the problems are — which translates to how thorough they believe their diligence has been in scoping the problem
  • Do they have motivesthat mitigate revenue weaknesses — cash flow, profit, assets

So if you have invoices in AR that can’t be substantiated. Of if you’re booking is inconsistent, undocumented, or just plain wrong. Or if you misclassify non-recurring as recurring, be prepared to see your 8x valuation drop to something less. It’s pretty likely that uncertainty in revenue will be used as a negotiation bargaining chip. And that can get nasty. (In my opinion, it’s best for the deal for founders to stay off of those calls and let accountants and attorneys hash that out so you can keep your blood pressure down.) These types of things can feel like attacks.

SaaS revenue weakness consequences

If you know or think you have SaaS revenue weaknesses that are likely to be exposed, be prepared for the following:

  • Extra deep, thorough (read painful, expensive, resource-intensive and time-consuming) revenue and contractual diligence follow-on questions and documentation
  • Discounts on valuation resulting in a reduction of overall deal value (likely late in the game)
  • Extra time (read fees and closing timeline delays) for accountants and attorneys to negotiate how the weaknesses are mitigated on both sides

Consequences of being unprepared in SaaS revenue churn

Revenue churnis both an automatic discount of revenue and a massive indicator of market fit and future value predictor. Whatever you say your revenue churn is had better be correct, or like revenue, you’re gonna take some hits. I see it as the #1 suspect metric in SaaS due diligence. Everybody wants to unpack churn and validate it down to the penny. (Alright, maybe not the penny, but you get the idea.)

Being unprepared in churn due diligence might translate to churning (or not churning) revenue on the correct date. It might look like booking expansion MRR that’s actually non-recurring. It could be that your contractions aren’t properly booked. Or that customers who pause (forever?) are still “customers”. There are a lot of ways to screw up churn. And, quite frankly, there are a lot of lenses that people look through here, so it’s easier than you might think to feel unprepared for this one.

SaaS churn weakness discount factors

Some of these are similar but different than weak revenue discount factors. I have a lot of maybesin these churn factors because that’s how churn is. It’s a very maybething (and you need to be prepared for that):

  • If your growth outpaces your churn (meaning your revenue is so strong that nobody cares) then maybeyour churn weakness gets overlooked
  • But if your churn weakness is GAAP more than it is real, maybeit’s less important
  • If your churn weakness nets out to roughly the same numbers despite underlying problems, maybeit doesn’t matter

SaaS revenue churn weakness consequences

If you think or know you have weakness in your churn bookings, be prepared for outcomes like these:

  • Extra deep, thorough (read painful, expensive, resource-intensive and time-consuming) churn diligence follow-on questions and documentation — including additional customer and ex-customer interviews
  • Discounts on valuation resulting in a reduction of overall deal value (likely late in the game)
  • Extra time (read fees and closing timeline delays) for accountants and attorneys to negotiate how the weaknesses are mitigated on both sides

These are similar to revenue consequences but there’s an important cautionary difference. Churn weakness is often less expected because churn world views can be so divergent. So churn weakness can catch you by surprise when you think you’re well prepared. Just be ready to dig in, go back, justify your process, and defend your numbers. If they smell something bad in churn, you’re in for a deep dive in due diligence.

Consequences of being unprepared in SaaS COGS

What sits above and below the line in cost-of-goods versus operating expensehas a lot to do with how a SaaS company is perceived and valued. SaaS companies are expected to have a relatively low cost to deliver revenue (15-30% depending on services mix). If that cost is understated, there are consequences.

If you’ve got any customer support or customer success wages or other costs down below the line in opex, they’re getting re-classed. Or maybe you’ve got some infrastructure stuff down in expenses rather than COGS. Or perhaps you have stuff down in R&D that’s actually viewed as cost-to-deliver. And there’s the common one that drops services costs down to opex when it’s rightfully COGS.

If your COGS percentage is 10% and gets recast to 26% expect these consequences

I’m not going to talk through any mitigators here because I think they’re less likely to apply. Understated COGS will have impacts unless you’re being bought for EBITDA (which is unchanged regardless of how things move around up in the income statement). But if you’re a revenue-valued SaaS, here are some of the consequences to be prepared for:

  • No matter what, you’re likely to take a hit to closing valuation in that your deferred revenue is subtracted as a liability. But, in practice, what’s actually subtracted is often the cost to deliverthat deferred liability, so your COGS percentage is used here. If you have $6M in deferred revenue and 10% COGS you’ll take a $600,000 hit. But if your COGS is recast to 26% you’ll take a $1.56M hit.
  • If your recast COGS is too far flung from your LOI COGS your deal could die. This is because it’s a fundamental value prop of SaaS companies and many investors and institutions have COGS guidelines that govern what constitutes an investible SaaS company.
  • Recast COGS is a negotiating opportunity that relates to future value and scalability. It’s likely that a SaaS company’s COGS pattern is reduction with scale. If recast COGS shows that’s not the case, credit for future value will be reduced, which could manifest as a rather random-feeling reduction in overall multiple. This becomes an opinionated debate, so just be ready for this potential outcome. It’s basically the argument that the company’s maturityis less than anticipated in the LOI.

Preparation for be unprepared for SaaS due diligence

All you can really do is be prepared when you’re unprepared. You get into trouble when you hold your lack of preparedness against your investor. It’s not their fault you’re not ready. It’s yours. And that will cost you time, resources, and money. You’ll get through that reality much easier if you go in understanding and accepting the potential consequences. These processes are stressful and tough enough without outsized expectations.

This is not to say that you accept outsized consequences either. Of course, you and your team of accountants, attorneys, and bankersare going to defend every term and dollar. But weaknesses have consequences in negotiations, diligence depth, closing timelines, and closing valuations. As long as you understand that going in, you’ll be in a better place to weather the storms and still close the deal.

Content by Beacon9 SaaS Business Advisory

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