How to Perform a Preliminary Evaluation Before Making an Offer On a SaaS Business.

The allure of acquiring an established SaaS business is undeniable. With predictable, recurring revenue streams and the potential for exponential growth, these businesses are highly sought after by investors and entrepreneurs alike. However, not all SaaS businesses are created equal, and diving into an acquisition without a thorough evaluation can lead to unexpected pitfalls and financial headaches. That’s why the preliminary evaluation is a crucial first step.

This is what you should be evaluating after you have gotten the confidential information memo (CIM), before you make an offer. In this guide, we'll break down the key factors to consider during the preliminary evaluation phase to help you identify promising opportunities and avoid common traps.

Revenue, Profitability, and Growth Trends

When evaluating a SaaS business, the first and most crucial area to examine is its profitability, revenue, and growth trajectory. These metrics provide a clear picture of the business's financial health and potential for future success.

Start by looking at net profit margins. For a small SaaS business, net margins should ideally be at least 50%. High profitability is a hallmark of SaaS businesses due to their low cost of goods sold (COGS) and scalable nature. If margins are below this threshold, it could indicate excessive expenses, such as high customer acquisition costs, development costs, or inefficient operations. A business with consistently strong net margins is likely to be well-managed and positioned for sustainable growth.

Next, analyze Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR). These figures are foundational for any SaaS business, representing the predictable, recurring income that the company generates. Ideally, you want to see consistent growth in MRR and ARR over the past 12 to 24 months. A steady increase in these metrics suggests that the business is successfully acquiring and retaining customers, indicating a strong product-market fit and effective sales processes. Seasonal spikes or dips might be normal depending on the industry, but erratic revenue patterns can be a red flag signaling deeper issues.

Beyond revenue and profit margins, it’s important to consider overall revenue composition. Is the business reliant on a single product or service, or does it have multiple offerings? A diversified revenue stream reduces risk and can be an indicator of a resilient business model. Similarly, assess the ratio of new versus returning customers. A high percentage of revenue from existing customers indicates good retention and potential for upselling, which are positive signs of a healthy business.

Customer Base and Churn Analysis

A SaaS business is only as strong as its customer base. Understanding who the customers are, how loyal they are, and how much they contribute to the business's revenue can provide significant insights into the business's sustainability and growth potential.

Start by analyzing the distribution of the customer base. A diversified customer base is generally a positive sign, as it indicates that the business is not overly reliant on a few key clients. If a large percentage of revenue comes from a small group of customers, the business could be at risk. Losing one or two of these clients could have a significant impact on the business's financial stability. Ideally, no single customer should account for more than 10-15% of total revenue.

Next, evaluate the churn rate, which measures the percentage of customers who cancel their subscription during a given period. A high churn rate can be disastrous for a SaaS business, as it erodes the customer base faster than new customers can be acquired. Calculate both the monthly and annual churn rates to get a comprehensive view of customer retention. A churn rate below 5% annually is generally considered healthy, while anything above 10% could be a cause for concern. Understanding why customers are leaving—whether it's due to dissatisfaction with the product, better alternatives in the market, or budget constraints—can provide valuable insights into areas that need improvement.

Finally, compare the Customer Acquisition Cost (CAC) to the Customer Lifetime Value (CLTV). A high CLTV relative to CAC indicates that the business can grow profitably, as the revenue generated from a customer far outweighs the cost of acquiring them. A good benchmark for SaaS is a CLTV to CAC ratio of 3:1, meaning that the business earns three times more from a customer than it spends to acquire them. If this ratio is below 1:1, the business is essentially losing money on each customer, which is a significant red flag.

Market Position and Competition

Understanding the business’s position in the market and the competitive landscape is crucial for assessing its potential for growth and long-term sustainability. Start by evaluating the product-market fit. Does the product solve a significant problem for its customers, and is there a strong demand for it? A product with a clear value proposition that addresses a specific pain point is more likely to maintain a loyal customer base and attract new users.

Next, examine the competitive landscape. Identify the key players in the space and how the business differentiates itself. Does it offer unique features, better pricing, or superior customer support compared to its competitors? The presence of many well-established competitors can be both a challenge and an opportunity. While it may indicate a saturated market, it can also validate the demand for the product. However, if the business lacks a clear competitive advantage, it may struggle to stand out and grow.

Lastly, consider the growth potential of the market. Are there untapped opportunities, such as expanding into new regions, industries, or demographics? Look at the business’s growth strategy and product roadmap. A strong roadmap that aligns with market trends can be a good indicator of future growth potential. If the business has already reached a high level of market penetration, further growth might be limited, and this should be factored into your evaluation.

By carefully assessing these aspects, you can get a clearer picture of the business's strengths, weaknesses, and overall potential, setting the stage for a more detailed due diligence process.

Operational Efficiency

Once you’ve established that the SaaS business has healthy profitability and a solid customer base, the next step is to evaluate its operational efficiency. This includes examining the team structure, day-to-day processes, and the overall scalability of the operations. A well-run SaaS business should have streamlined processes that minimize the need for constant oversight and intervention.

Start by assessing the current team and their roles. Does the business rely heavily on the founder or a few key individuals? High dependency on the current owner can be a significant risk, especially if they are planning to exit post-sale. Ideally, the business should have a team or contractors in place who can manage the daily operations without heavy reliance on any single individual. Look for signs of a well-defined organizational structure, such as clear roles and responsibilities, documented processes, and a robust support system.

Next, consider the automation of critical functions like customer support, billing, and product updates. Efficient SaaS businesses leverage automation tools to handle routine tasks, reducing the need for manual intervention. Check whether the business uses a customer relationship management (CRM) system, automated billing software, and support ticketing systems. Automation not only reduces operational costs but also minimizes errors and improves the overall customer experience.

The scalability of the infrastructure is another important factor. The business should have a technology stack that can easily accommodate growth in user base and traffic. Assess the scalability of the cloud hosting, the robustness of the codebase, and the process for deploying updates. If the business can scale without significant additional costs, it is well-positioned for growth.

Technical Due Diligence

In any SaaS acquisition, understanding the technical underpinnings of the business is crucial. You need to know what you’re getting into before committing. This involves a deep dive into the technology stack, the quality of the code, and the development practices currently in place.

Begin by reviewing the tech stack. Is the software built on modern, widely-used technologies, or is it reliant on outdated or niche technologies that could limit future development? The use of a modern tech stack not only makes it easier to find developers to maintain and improve the product but also ensures better performance and security.

Next, assess the quality of the codebase. If possible, have a trusted developer or technical advisor review the code for maintainability, scalability, and security. A clean, well-documented codebase is a good sign that the development team has followed best practices, making future updates and bug fixes easier to implement. On the other hand, a poorly written or undocumented codebase can be a red flag, indicating that you may face higher development costs and potential issues down the line.

Finally, look at the development process itself. How often are updates and new features released? Is there a clear product roadmap? A SaaS business with a proactive development team and a well-thought-out product roadmap is likely to continue growing and evolving in response to customer needs and market changes. This is crucial for long-term sustainability and competitiveness.

Financial Health

While you’ve already looked at profitability, a deeper dive into the financials is necessary to understand the full picture. Start with a detailed review of the profit and loss (P&L) statements for the past two to three years. This will give you a clearer view of the business’s financial trajectory, including revenue growth, cost management, and profitability trends.

Pay particular attention to the cost structure. SaaS businesses typically have high gross margins, but other operational expenses can vary widely. Evaluate costs related to customer acquisition, development, support, and overhead. Compare these costs as a percentage of revenue to industry benchmarks. Excessive costs in any area could indicate inefficiencies that need to be addressed post-acquisition.

Another key area is cash flow. While SaaS businesses often have predictable revenue, they can also experience cash flow challenges, especially if they offer annual subscriptions with upfront discounts. Look at the business’s cash flow statements to understand how cash is being managed and whether there are any liquidity issues.

Lastly, check for any outstanding debts or liabilities. These could include loans, unpaid invoices, or legal issues that could impact the business post-acquisition. A clean balance sheet with minimal liabilities is a good sign, but any significant debts or obligations should be factored into your valuation and negotiation strategy.

On That Note;

By focusing on key areas like profitability, customer base, market position, operational efficiency, technical due diligence, and financial health, you can quickly identify whether a business is worth pursuing further. Remember, the goal at this stage is not to uncover every detail but to get a clear enough picture to decide whether to move forward with detailed due diligence.

Acquiring a SaaS business can be a lucrative opportunity if done right. A thorough preliminary evaluation will provide the insights needed to make informed decisions, negotiate effectively, and ultimately acquire a business that aligns with your strategic goals.