Key Red Flags and Focus Areas for Buyers of SaaS Businesses

Key Red Flags and Focus Areas for Buyers of SaaS Businesses

December 20, 2022

Software as a service (SaaS) represents a business model that brings special considerations throughout an M&A transaction. Several indicators present themselves as potential red flags for buyers of SaaS businesses. Additionally, there are some areas during a transaction of which buyers should be thoughtful since they could impact the underlying economics of the deal. These areas and indicators are also common areas of dispute in M&A transactions, so buyers must perform the appropriate diligence to get ahead of potential issues.

High Churn

Churn represents the rate at which customers cancel their subscriptions. High churn may indicate issues with customer loyalty, ineffective marketing, or a competitive product or service, which may represent an unsustainable business. However, it may also present opportunities for a buyer to reduce churn through operational improvements. As a result, it is important to discuss churn with the target business to understand the potential drivers of such metrics as best as possible.

Declining Revenue

Churn or a decrease in the average revenue per customer can drive declining monthly recurring revenue. Buyers must understand the drivers in the changes to average revenue per user. Generally, decreased revenue per customer is a result of actions such as customer downgrades or decreased pricing. However, they should be understood together with the other metrics discussed.

For example, a business with price-sensitive customers may lower their price, which results in a decreased average revenue per user, but such price adjustments may lead to less churn and a greater customer lifetime value. Alternatively, customers may be shifting to longer-term or discounted contracts. It is imperative to get management’s commentary on the trends to SaaS metrics and rationale for operational changes – such as price changes or subscription contract changes.

Capitalized Internal Labor

Another sensitive area for SaaS deals is capitalized labor. GAAP (Generally Accepted Accounting Principles) allows for the capitalization of costs to develop both internal and external use software, albeit with different requirements to qualify for capitalization. While allowable under GAAP, these expenses often are more operational in nature for businesses that are continually developing software.

As a buyer, it is important to understand the costs that have been capitalized, how much of that is internal versus external, and what types of internal costs are being capitalized. While all capitalized costs may continue to be incurred, internal costs take more effort and cost to shut down, and thus generally represent an ongoing operational cost of the business. For example, an employee no longer developing new software may get redirected to a different project or initiative, or a contractor no longer developing new software will simply end their engagement.

Some companies simply capitalize an employee’s salary, while others capitalize their fully loaded cost and related overhead. Buyers should ensure they have a good understanding of a target company’s capitalization policies as well as the nature of the expenses being capitalized. Lastly, a buyer should ensure their financial models capture the ongoing necessary development spend either in earnings before interest, taxes, depreciation, and amortization (EBITDA) as an expense or in ongoing capital expenditure as an ongoing capitalized cost.

Deferred Revenue

In many cash-free, debt-free transactions outside of SaaS, it is a foregone conclusion that deferred revenue (or customer deposits) be treated as debt-like and results in a reduction to the purchase price at close. This is because such amounts represent a buyer’s obligation to provide products or services to customers, for which the seller has already been compensated – particularly since the seller takes the cash at close. Additionally, the buyer may be obligated to pay taxes on the income when recognized in future periods while not receiving the cash for the initial sale.

However, this concept can become cloudy and lead to tension in a deal process, especially in certain SaaS or software deals where the cost to service the revenue may be insignificant or has already been paid—such as with sales commissions. Buyers should be thoughtful on the nature of the deferred revenue and the true obligation they are inheriting.

Buyers may wish to explicitly state how deferred revenue be treated within their letter of intent to avoid further disputes or re-trading later in a transaction. Regardless of how deferred revenue is handled, buyers may be required to service such amounts post-transaction while not receiving the cash.

Sales Commissions and Deferred Costs

Prior to ASC 606 and ASC 340-40, companies usually expensed sales commissions as incurred. Under the new guidance, companies generally are required to capitalize such amounts unless the amortization would be less than one year. The useful life is based on the expected customer life, which should factor in an estimate for renewals. The guidance is a bit more complex, as it should also factor such aspects as churn, the period of time to which the commission relates, and the life of the product or service.

Similar to deferred revenue discussed above, GAAP may result in significant variances to the cash flow related to commissions. Companies with high growth may cause large cash commissions to be paid, with only a portion of those cash expenses resulting in GAAP expenses that affect reported EBITDA. Conversely, companies that reach maturity may have large GAAP expenses for commissions that have already been paid in prior years to establish the current customer base. As a result, we often look at EBITDA for SaaS companies on a GAAP basis, as well as a cash or billings basis, adjusting both deferred revenue and deferred costs to a cash basis.

Buyer Beware

Metrics such as churn, monthly recurring revenue, and average revenue per user often provide valuable insight into the state of a potential SaaS acquisition. However, given the nature of the business and the complexity of arriving at such metrics, buyers should discuss continually with the acquisition target how those metrics were arrived at and what they mean for the company’s overall state.

Buyers should be thoughtful of how capitalized labor, deferred revenue, and deferred costs are considered in their model and their purchase agreement to avoid potential transaction disputes. Given the unique characteristics of SaaS transactions, diligence providers can provide a valuable service to avoid the potential pitfalls and many of the issues that are common in such transactions.

Reprinted with permission from Bloomberg Tax.