8 Buying SaaS Businesses Insights I Learned from David Newell’s SaaS Business Valuation Guide

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David Newell - Author of Buying, Operating, and Selling SaaS Businesses

David Newell from Quiet Light Brokerage is one of the most seasoned SaaS-oriented brokers in the online buying and selling community.  He recently dropped a 13,000(!) word knowledge-bomb on the topic of How To Build, Value, and Sell A SaaS Business for 6, 7 or 8 Figures.

I’m fortunate enough to have bought a SaaS business from him in the past and he is truly one of the marquee brokers professionalizing our industry. His 60-page article is a must-read for anyone that is building, operating, or transacting in the sub $5M SaaS world.

Much of the article provides a solid background on buying SaaS businesses, but it does also have some intriguing nuggets even for more experienced SaaS operators and buyers that go beyond the beginner basics.

In this essay, I pull out what I thought were the eight most interesting takeaways that I learned from his article and sprinkle in some of my own opinions about our acquisition space.

1) Developers Can Unlock Tons of Additional Income

Let’s look at how brokers set up a business for sale:

“The key-man risk associated with the business is very high, presenting buyers with a major transferability issue (a key valuation pillar). This translates into a discounted multiple, an earnout offer structure (to de-risk the deal), or a very extended transition and training period. None of which is particularly ideal for the owner.”

“A smart, de-risked way to bring in a third-party developer (contractor or employee) is to have them learn the codebase and document it at the same time (code architecture map, annotations, etc).”

“In a best-case scenario, you want to demonstrate to a buyer that the developer has worked for you for a long period of time and had experience shipping major developments with the software.”

What does this all mean to developers and technically experienced professionals on the buy-side?

Brokers require sellers to set up their SaaS businesses to be sold to passive investors, not technically oriented operators like developers, engineers, and IT professionals.

Passive Investors vs. Developers / IT Investors

For a SaaS business seller that was founder run, brokers usually will want the selling founder to set up either a team before selling or have one ready to step in on day one.

This lowers the purchase price because that developer cost lowers the eventual SDE and sale price.

This can be a huge opportunity for developers, or people who have technical experience, or anyone who has managed technical teams before.

As a developer or technical oriented operator, you can purchase the business and either replace the team yourself or bring in a more competent, focused, and less expensive team that you already work with on other businesses.

Since technical help often is the most expensive part of your P&L (after the cost of taxes), this can immediately juice the returns of your business.

Unlocking Value with a SaaS Business Buying Example

When I bought the founder-run business Appointment Reminder, the broker made the seller spend six months training up a team of remote developers to be ready to go to assist me with the business.

Once I had bought the business, I dropped that contract and had my own team just absorb those tasks as another responsibility in their daily functions. (It really helps to always buy businesses in the same tech stack. I’m going to write an article on this concept soon.)

I earned back the equivalent of one year of expenses immediately from that move alone. Instead of taking four years to earn my money back, it would theoretically only take three.

2) The Differences Between Value and What You Get

“Your business’s worth is based on who is out there to buy it in the first place.”

“How much is my SaaS business worth?” is best answered as “It depends on who you sell it to.”

The difference between value and what you get is:

  • Value is how much the business is worth using common valuation methods.
  • What You Get is what it can be sold for in the market.

And rarely the two shall meet.

Your business’ worth is based on who is out there to buy it in the first place and what they say it’s worth.

I run some esoteric businesses where there aren’t a lot of buyers that would pay what I believe is the true value for the business. My value and what I would earn on a sale may not match up.

I can live with that, but only because I don’t go to market assuming I can achieve a sale price that will match what I believe the business is truly worth.

3) Sellers: Understanding the Buying SaaS Business Landscape

Sub $3M Threshold

“…you can see that in the $100K to $3M exit landscape, the vast majority of exits (by volume and value) are made to individual, portfolio, or syndicated buyer types.”

 Microfunds/Syndicates:  They differ from private equity in that they do not have institutional financing and acquire 100% of the company at closing.

Under $3M, you’re likely only interested in a few types of buyers, and very likely not private equity and strategic parties.

“Private equity investors aim to incentivize the owner to stay on for at least 18 to 24 months post-sale to work towards pre-agreed revenue and/or development targets.”

At a certain revenue point and complexity of the business, it’s almost unavoidable that there’s going to be some post-sale work unless you’re willing to give up a lot of cash at closing.

But under that purchase price level, my recommendation is to get as much cash upfront as possible, with as little post-sale work as possible, and don’t settle for ‘holdbacks’. Holdbacks, which I cover below, are dependent on hitting revenue or development targets where the acquirer determines your “success” in the future. You never know when a pandemic of global proportions might show up and evaporate that holdback payoff.

Above $3M threshold

“Above the $3M threshold, the landscape shifts towards PE and strategic buyers. They focus on revenue-multiple and are willing to pay more, but often want the owner as a part of the deal, working for 18 to 24 months post-sale.”

Above $3M, your choices about selling, taking the cash and walking away get more limited.

There are many cases where getting money off the table is a good idea, even if you end up with a job from the old business you just sold for a year or two. Just be aware that if you’re a serial entrepreneur, you may want to conder selling before you reach that level and move on to buy your next business.

4) Holdbacks (Sub $3M Range)

If there is a substantial performance component to the deal, then there should be an emphasis on the skill and experience of the acquirer to ensure they can achieve those goals and future payments. 

My opinion on holdbacks?

Pandemics…enough said.

Try and stay away from holdbacks as much as possible.

Remember, the acquirer is the entity that determines if the goals are reached in the future.

And let’s face it, business accounting can reclassify a lot of expenses, assets, revenues, and marketing efforts into other categories that can change key metrics in any direction an accountant would desire.

Holdbacks are standard for larger deals, but don’t let smaller sellers try and “pull-down” holdback standards from the upper echelons of PE firms and act like that’s acceptable under $3M.

5) SBA Eligibility for Buyers

“SBA eligibility significantly increases buyer demand. That’s because they only need a 10% to 20% down payment on an SBA loan to buy a business. If you’re selling for $3M, for example, there are a lot more buyers with $300K in cash than there are with $3M in cash. Because there’s more demand, you can qualify for a higher multiple.”

 “SBA loan deals do not come with any earnouts or holdbacks either. As the seller, that means you’ll receive between 90% to 100% of the deal value in cash at closing. That’s definitely a strong incentive!” 

As a SaaS business buyer, get pre-qualified before you start looking for deals.

As a SaaS business seller, go through the seller SBA process, it’s painful and annoying, but do it. You can get really qualified buyers that have less cash, but more experience, that can really take your business and run with it.

6) SBA and SDE Add-Backs

“The banks and SBA don’t participate in the adding back of expenses that we discussed in the SDE valuation section of this guide. Instead, they rely largely on the bottom-line net profit.”

This oddity of SBA sales changes how I look at my business in the 12-18 months prior to a potential sale.

If expenses like salary, health insurance, training, R&D, etc. aren’t added back in, then I’m not going to run those necessary expenses in the years prior to a sale. (This is why it’s helpful to have multiple businesses where one that you don’t care about selling can be your “overhead business”. Another article I have coming out soon, stay tuned.)

As a buyer, realize an SBA-backed business likely has some costs and expenses neglected that should have been in the business previously. Tasks that good businesses should be doing, like R&D, new customer acquisition, advertising, etc. may have been ignored for 12-18 months. This SBA rule encourages sellers to leave a well-running business on auto-pilot for a year or so and not invest in the business because it would lower the price of the eventual sale.

Just something to keep in mind when looking at SBA-approved businesses.

7) Buyer Beware of Broker Choice on What Is Really SDE

There are not many direct quotes from the article on this tactic…but between the lines, there are hints of how brokers use a “massaging” of valuation periods to improve their asking price.

Here are a few things I always look out for:

Non-Standardized SDE Time Periods

Certain brokers use no standardization of SDE models, they just choose “Whatever trailing model looks best in the last 36 months“.

Sometimes it’s the last 3 months, sometimes it’s the last 18 months excepting the last 3 months.

Make sure you are comparing apples to apples when looking at buying SaaS businesses and using the previous performances of similar businesses for comparisons. Some brokers are more notorious for this practice, others don’t do it at all.

Annualizing Current MRR (“Run-Rate”):

However, in some cases, it makes more sense to use either the last six months (L6M), the last three months (L3M), or even the last month (L1M) and annualize that number instead. If you’re in a scenario where your SaaS is growing very quickly, it’s not appropriate to use the last 12 months. Growth over the last 12 months justifies the re-rating. Customer metrics (like churn and LTV) are stable or improving. 

This is the most common method of inflating sales prices. It involves annualizing the most recent months of revenue instead of calculating the last 12-24 months. Those months are guaranteed to be juiced for maximum gains. The business likely had a drop in expenses and a mysterious increase in revenue.

Remember, to bring a business to market, a broker will spend months getting it prepared and looking good to potential buyers. They are basically “staging” the business, just like you stage a house for sale.

Then suddenly at the end of this process, the business has an incredible month or two and they decide to base the price on that purely happenstance great time period? Hmmmm….

High Paying Customers That Aren’t Real Customers

Possibly in conjunction with #2, verify in your due diligence that all high-paying customers have been with the business a long time, are legitimate businesses, and not just the seller’s friends juicing up the bottom line that will slowly disappear after the sale.

Every single one of my businesses could easily add one or two fake accounts a month for half a year which would really increase my sale price.

Does that high-value subscription have usage? Is it a real business that’s verifiable? Those types of metrics are harder to fake. Could there exist a seller PBN-style of business that’s not spoken about that provides this type of service?

OK, now I’m getting a bit too paranoid…

One Time Gains Added to Sale Price Calculation

A fairly common way a sale price is inflated is a company that has a one-time product offering (software upgrade, etc.) that is factored into the sale price as if it’s a repeatable, normal revenue driver of the business.

One-time product offerings that required 12 months of work for that one-month launch are not repeatable for a new buyer. A new buyer would have to spend all of that R&D money again on the next version but would never get the benefit of the one quoted in the prospectus.

Let’s take an example, a business that makes a net profit of $3k per month has a new product upgrade version come out in July that nets $30k that month. The valuation will take into account that $30k per month, even though the buyer gets zero of that income, it is not repeatable, and does nothing but increase the sale price.

The seller gets the $30k and gets to bump up the sale price for what is really a one-time product sale.

Just pretend that this bump in revenue was actually a one-time expense? A broker would call that an “add-back” and subtract that one-time event from the expenses line. But since its profit, it’s left in there to boost the sale price.

Keep an eye out for those…

8) Brokers Protections

Enough bashing brokers! I actually do love brokers and they do a tremendous amount of great work under the hood so you don’t even have to realize how complex this business really is on a day-to-day basis.

Hiring an advisor means you get access to their list of vetted, pre-qualified buyers. These buyers trust that broker to bring good deals.

There is a discount on the sale price if I have to teach you how to sell your business.

Don’t bother looking for that last quote in the article, that one is mine. Brokers provide a ton of value for their cut of the sale.

If a seller doesn’t want to use a broker to sell the business, then I want a discount (roughly equal to what they would have paid the broker) because now I have to do all that work and it’s a real pain.

Many buyers will gladly do that grunt work for a possible sale, but that’s something I believe should be done by an expert and experts should always be paid well for their services.

Bonus, there are nine items!

9) Why Annual Plans Stink for Buying SaaS Businesses

Monthly to Annual Plan Ratio: As a rule of thumb, monthly recurring revenue is more valuable than annual recurring revenue (i.e., monthly plans vs. annual plans) because MRR is more predictable.

Thank you David for someone finally saying this about annual plans!

I’ve always believed annual plans were a terrible idea for many businesses. If I buy a business that has annual plans, I halt the sale of any new annual subscriptions moving forward.

Why are Annual Plans a Bad Idea?

Annual plans are a pain for accounting, a pain for getting the credit card to work the next year, and why do I need to give a 10-20% discount just because a customer wants to pay upfront now? If you want to pay upfront, that’s great, but it’s still going to be full price.

In many cases, businesses want the cash upfront at a 20% discount because they want to invest that cash immediately in finding new customers. Ok…that’s great if you’re running a business with no cash in the bank, but if that’s the case in our sub $5M world, you have other issues. You’re basically paying 20% interest on a one-year loan. That’s predatory loan interest levels.

Would you take out a one-year loan at 20% interest to buy Google Ads for your business?

Enough of my opinion about the worthlessness of Google Ads and my opinions on selling annual plans, let’s dig into this a bit.

Free Labor for the Seller, Liability for the Buyer

For any business sale, each annual plan is a liability to the buyer. Each annual plan your buyer has to serve…but was never paid to do the work. It’s free work for the SaaS business seller and liability for the SaaS business buyer.

Bad Customers Might Only Be On Annual Plans

Many times I have seen customers on annual plans because they are bad customers, not because they are good customers.

I primarily do annual plans for customers that I decide either need to be fired or can stay if they agree to pay in full a year in advance.

These are the type of customers that are such problems that only earning one or two months of revenue is not enough to keep them around, they must pay one year upfront for me to let them stay as a customer. I’m sure I’ll do an article about firing bad customers soon.

You may find that the annual plans you are counting on as revenue in eight months never pay again because they were all bad customers in the first place.

Factored into the Sale Price?

I know brokers say they factor annual plans into the sale price, but I’ve never seen any broker break it down and say “This business is worth $1,230,000 at 4x but we’ve lowered the price to $967,500 because of the annual plans.”

They list it at $1,230,000 and claim it was lowered to compensate for annual plans.

Sure…sure it was.

 Summary

Hopefully, my thoughts above highlighted some of the things I’ve learned from David about buying SaaS businesses in the past.

Dave did an awesome job of really pulling out the details of many complex moving pieces both for sellers, operators, and buyers alike. Many thanks to him and I’m sure I’ll be coming back to his essay many times over the next few months.

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