This is one of the most common questions we get asked and it implies that there is some secret source of great micro-SaaS companies that is hidden from the rest of the world. There isn’t. While some uniqueness exists to each firm’s dealflow based on direct referrals and inbound queries, they all use similar channels like brokers, cold outreach, marketplaces etc. And there are hundreds of articles by other SaaS-focused acquisition firms explaining these. Thus, we probably see many of the same deals as the other established lower middle-market firms.
Instead, one of our key differentiators is not finding new dealflow, but creating acquisition opportunities out of seemingly untenable SaaS companies. This needs serious effort, skill, time, and creative deal structuring to ensure risk remains low without degrading potential upside for our portfolio. It also ensures that firms that look at deals with only a broad financials-heavy lens don’t eat our lunch.
Looking Beyond Financials
Most firms worth their salt look at company financials and related items competently. They try to understand the standard financial and customer / SaaS metrics related to the business. Some also consider their ability to reduce the cost structure of a target or find new channels to market and grow the business. This likely works well for certain businesses and acquirers, but in domains where product and technology can be fairly deep and differentiated, and impact business outcome, lots of value is left on the table by not taking a product-centric approach to due diligence.
At Alleyway Capital, we do this for all our target acquisitions. We certainly look at financial and SaaS metrics, but we spend a lot of time considering opportunities to add value by upgrading the product or continuing to implement an unfinished roadmap. In our latest acquisition (Visual Quiz Builder) we saw reasonable financial / SaaS metrics but that only made this an okay deal. This acquisition went from passable to great when we researched the product, the underlying design and the code. We found ample scope for further growth just improving these aspects beyond the financial and business picture. It took great passion for the product and some serious technical knowledge to be able to identify these gaps in the company, but it ensured that we found ourselves a stellar acquisition in a crowded SaaS market where multiple firms look only at sales, customer metrics and other such financial or operational data to gauge the upside in an acquisition.
Dealing with Unknowns
When digging deeper than just financial analysis in a business, especially in areas like product code, feature improvements and the like, it is rare that these items are properly listed or even identifiable in smaller companies. Even slightly larger SaaS businesses tend to have at least most of their basic financials in order, but the product and technology can become a mangled behemoth of code, comments and third-party integrations.
The above situation, in large part, is created by just-in-time development frameworks (we are looking at you AGILE) and the coding over engineering mindset prevalent today. While this leads to some very productive software teams that iterate rapidly, the documentation and overall ability for knowledge transfer, technical investigation and product analysis is diminished when considering an acquisition.
When going deep beyond financial data, it is almost a certainty that not all risk analysis and product investigation will be possible pre-acquisition. Either because the data just cannot be located or the analysis is cost/time prohibitive. Some of these will surface post-acquisition and some of it will be discovered during ownership and operation of the business. To prevent losing out on a potentially great acquisition due to due diligence fatigue from the unknowns, there are ways to creatively structure deals. This can help give sellers a fair consideration without requiring all data to present upfront for the buyer.
Creative Deal Structuring
When encountering unknowns during due diligence, one of the ways to overcome this is to renegotiate the total price being offered. This could potentially lead to the seller walking away. In such instances, there are a number of creative ideas to restructure acquisitions that help balance risk and align objectives between the seller and buyer without changing the total consideration. Here are some common ones:
Seller financing wherein the seller carries a portion of the consideration (total acquisition price) as a note. This is typically not a popular structure unless the business is in distress or has other problems.
Milestone-based payout wherein the seller receives payments as certain milestones are achieved (these can get complicated and contentious so simple conditions like time should be used).
Earnout wherein the seller earns certain payouts based on business performance (again, keep these conditions simple to prevent issues later).
During due diligence on our most recent acquisition we found that the financials of the business lined up to a large degree with our initial expectations, but a number of other key areas had missing information. Especially the state of the codebase and deep product customizations we encountered during our investigations required proper technical documentation to ensure a smooth transition of the business to our team. However, most of this documentation was not available as is common with technology that is developed rapidly in smaller software startups.
Rather than kill a potentially great acquisition by drastically lowering the consideration offered or demanding all the documentation upfront, we worked towards a creative structure consisting of tiered earnouts and two types of milestone-based payouts (a holdback and an escrow). Foremost, the earnouts created alignment between all parties as the seller would be given extra payouts based on the level of revenue growth achieved by the business in the coming several months. Also, the holdback ensured we did not rush to transfer every single business asset on closing day and that the assets plus operational knowledge could be transferred over a period of time after which the seller would get the remaining consideration (holdback amount). Finally, the escrow was created to ensure documentation is done on time and financial consideration attached to this is paid out as these documentation milestones are achieved by the seller’s team. Thus, the seller got the price they wanted while not having all information available prior to acquisition. This also ensured we were comfortable with the risk shared between both parties in the face of unknowns and missing due diligence items.