SaaS: some considerations in an M&A context

SaaS: some considerations in an M&A context

SaaS: some considerations in an M&A context

The enduring popularity of the software as a service (‘SaaS’) model continues to translate into associated M&A activity, as successful SaaS businesses remain attractive targets for trade buyers and other investors alike. In common with many other transactions, one of the core challenges for a buyer is to marry an (often) ambitious valuation of a target company with a more accurate picture of its true value. Here, we explore some of the core due diligence considerations involved in assisting with this judgement call.

Performance and revenue
The nature of the SaaS model itself should be taken into account. In many complex service provision arrangements it is common to see a link between the fees due for the service and the actual level of performance by the service provider. SaaS arrangements are no different, and an acquirer of a SaaS business will need to understand how the business commits to its customers in terms of service standards and whether a failure to achieve these has a direct contractual impact on revenue and/or could result in financial claims.

The existence of linked service levels, KPIs and service credits may not, of themselves, constitute cause for alarm, however effort needs to be made to understand how the business copes with these mechanisms – it may be, for example, that a SaaS business is heavily reliant on one particular software component which, if defective, will cause the business to miss service levels across its customer portfolio or, worse, trigger multiple material breaches. A business may have robust measures in place so this cannot happen.

Either way, those SaaS businesses with a scalable offering tend to offer the same or similar services across their customer portfolios (perhaps with various bespoke overlays), and it should always be borne in mind as part of any diligence exercise that an issue with the way a business provides its service to one customer may lead to similar issues with some or all of the target company’s other customers (whether actual or potential). It is not hard to see how this can have a significant impact on anticipated revenues and, potentially, deal value.

Security of revenues
SaaS businesses often receive payment for the service provided in instalments over time. Much of the value of these customer contracts is therefore in this earnout process over that time period, and it becomes important to ensure that the target’s customer contracts are not capable of early termination by the relevant customer without cause or of otherwise being triggered by a change of control or asset sale. Therefore fixed term deals must be checked for any cancellation rights.

Sometimes where contracts include such an early termination right for the customer, it is coupled with a termination payment designed to compensate the target business for some or all of the lost revenue it would have earned over the remainder of the contract term. These payments do warrant further analysis to ascertain their enforceability, especially with consumer contracts, to be comfortable that the target business has a secure revenue stream and that this is not affected by any proposed transaction.

The risk profile for SaaS businesses is often dictated by the sector in which they operate and whether they can support business critical functions to which potentially high liability levels are attached. One of the more important distinctions to be made is between the SaaS business taking responsibility for the performance of the service, whilst excluding liability for data inputted, the way it has been obtained in the first place (e.g. appropriate consents for processing personal data) and the accuracy or suitability of the output of the service. This can be a delicate balancing act, and it will be important for an acquirer to understand that the target business is not assuming liability for risks which are outside its control or ought properly to rest with the customer. A good example of this is SaaS in the financial services sector, particularly in a regulated context – here it is the responsibility of the customer to comply with its own regulatory requirements, and these obligations should not be passed onto the SaaS provider.

However, this may not be as simple in situations where the SaaS provider’s acts or omissions cause the customer to breach its own legal requirements, particularly if the provider is holding itself out as an expert in the particular sector. From the service provider’s perspective this liability should be resisted where possible (perhaps through only assuming liability for accurately performing a narrowly defined service specification), although the presence of a clearly drafted limit on this liability may also cause the issue to avoid ‘red flag’ status in a diligence exercise, particularly where it is backed up by a robust insurance policy.

SaaS clearly continues to be a hot topic in the world of software solutions. In addition to that, the ability of SaaS businesses to attract buyers valuing on a multiple of recurring revenue (as opposed to, for example, earnings/profit) helps make this an active M&A market sector. Entrepreneurs can target fast early growth, high cash burn on people and product, and little or no net profit with some confidence that a buyer will pay a recurring revenue multiple - based upon the expectation of significant profit and continued growth being generated by the business from its ever increasing customer base as it evolves into its next phase. This makes SaaS a sector in which, potentially, buyer and seller expectations can be more easily aligned than in some other areas. For the time being, therefore, there looks likely to remain a focus of M&A interest around those SaaS businesses which get both the product and the growth model right.

By Joe Bedford, Partner and Charles Maurice, Senior Associate
First published in ITProPortal, January 2017

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