(Originally published on TechCrunch)
There comes a time for many founders when they are ready to pass the baton of running their business to someone else. It’s a rare founder that wants to go from zero to running and scaling a large long-term company. When that time comes — you may have expectations on what you would like to exit for, or have read stories about other company valuations — but I thought it might be useful to share some of the other sides viewpoint. So, here are some of the criteria we use at Scaleworks when evaluating a new opportunity.
Rule 1 — Don’t Lose Money.
The cliche of course is ‘Rule number two: read rule number one’. Make sure any acquisition you consider is at a fair price, and that you have identified some ‘low-hanging fruit’ opportunities for improvement that you are confident in your ability to execute on.
What does a fair price mean?
For us — it means a price we have confidence we can either pay back over time from cash-flow, or sell the business on a profit multiple for the at least the same price we bought it for.
If the world changes and revenue based valuations go away for SaaS companies, make sure the ‘notional EBITDA’ (notional being if you ran the business for profit and cash flow — what would your earnings look like?) is enough that an exit on an EBITDA multiple will return your purchase price, or close to it (you can always run for cash for a period too, to return a % of the purchase price).
The more you pay for a business —in valuation terms (hopefully because it’s growing well and in a good market)- the less likely you are to be able to run it for cash flow or move to an EBITDA exit on day 1 and return your purchase price. So it’s important to identify ‘low-hanging fruit’ opportunities that you believe you have the skills to execute.
Identify Early Wins
Some examples of low-hanging fruit: under-investment in sales and marketing, a support team that isn’t realizing its full potential to serve customers, opportunities to do more for the existing customer base — and in providing more value, generate increased revenue and lower churn.
Look at your existing businesses unique skills — if you have sales expertise — maybe you can quickly build a much enhanced sales organization; if you’re a product person — maybe you see obvious gaps in the roadmap, on-boarding, or UI and UX.
Combining growth from executing the low-hanging fruit with paying a fair price, hopefully you’ve de-risked the deal to the point where losing-money has a low probability. This approach takes a lot of deals off the table pretty quickly — but if you believe in value and pragmatism then being the high-payer, regardless of the companies ‘future potential’ is too much of a lottery ticket to buy. Stick with backing yourself and your teams ability to deliver.
Ask ‘Why Am I the Lucky One’?
If this is a good business, and you are buying it at a fair price, why are there no other bidders, or why is your bid the best? Why are you the only one able to get it at this price? The market is supposed to be efficient! You know how the saying goes — “if you don’t know who the patsy is, it’s you”. Make sure you have plausible reasons why you are the one that is getting this business that others don’t value to the same degree you do. What do you know that they don’t? What skills and experience do you have that de-risks the deal, and justifies the price?
Ideas Should Be Plentiful
Whatever idea you come up with now is probably wrong, but if you’re buying the business at a fair price, there should be upside you can bring to the table. If you and your team have a stream of ideas for this business — new marketing ideas, product features, ideal customers, partnerships, opportunities to do more for existing customers — it’s a good sign that you’ll find some that work.
One of our principles is ‘Category Design’ — we want to create a category or sub-divide an existing category into one that we can own. Often that’s a smaller category than the one we acquired in — but being #1 is a whole lot easier than #5, and a good position of strength to grow from. Do you see ways to narrow the company’s focus that will provide category power?
On the other hand, if you are struggling to come up with credible ideas, don’t force an acquisition just because you like the price. Maybe the space isn’t mature enough yet, or you and your team aren’t the right fit for bringing a fresh perspective to it. Maybe it’s just too competitive, and you’re not getting inspiration on how to break out into a new category.
Ideas need to come easily, and be plentiful, otherwise what’s the upside potential? Don’t do a deal where all there is is downside protection — make sure there’s a chance to win big too!
- No Revenue 80/20. You don’t want 80% of revenue coming from 20% of customers. Don’t buy a business that has a few customers making up the bulk of revenue. It increases risk and reduces your growth levers and scalability. For a $10m ARR business, you want hundreds or thousands of customers, paying hundreds or thousands of dollars a month. There’s a margin of safety built in with a more numerous customer base.
- High Margins. Software, for now at least, is in the super-normal profit zone. Margins are 80% and above. While this can makes us lazy and financially inefficient — for prudent operators — it also creates a fantastic safety net when the economy goes through a downturn. The ability to suffer a revenue reduction, and restructure to be profitable or break-even, means your chance of coming out the other side of a set-back is high.
- Default: Alive. Do not buy a shrinking business. Warren Buffet says it simply: “turnarounds rarely turn around”. Why make life harder by taking on a challenge like this? If you buy a growing business — even if the assumed low-hanging-fruit doesn’t materialize and you find your ability to impact growth is low — you still have a good business!
- Manageable Churn and Healthy Install Base. Gross revenue churn — that is, the average monthly amount of revenue that cancels or does not renew — should be less than 2% (remember that’s a quarter of the business GONE in the first year you own it!) and the install base—revenue from existing customers, plus upgrades and less downgrades — should be flat or positive. Hopefully you see some ways to reduce churn and add more value to the install base. Ultimately — the goal is to get to a positive install base, where the business grows naturally.
Check the Finances
- Look for budget misalignment. Is one area getting more than its fair share of dollars, so that another is losing out? For example — is the Product and Engineering line eating up the bulk of the spend, while Sales and Marketing has a low allocation that stays flat? A rule of thumb for us is ‘equalize the buckets of cost’ — that means, after cost of business (should not be more than 20% in a SaaS company), sales and marketing, product and engineering, and general admin and management should be approximately ⅓ of the budget each.
- Validate Financials. Hopefully this is the most obvious statement. But — some things to look for — high AR (accounts receivable) could mean unrecognized churn; and high DR (deferred revenue) means customers you need to provide service for without getting paid, and that may not renew. Make sure the renewal and upgrade rate is high (a good rule of thumb is that at least 80% of customers renew and 20% upgrade —close to a flat installed base), otherwise you have a ‘leaky bucket’ problem. When you’re valuing a company based on a multiple of it’s revenue - paying for revenue you don’t receive and customers that may not renew doesn’t really make sense!
The summary we like to use is this 3-fold check:
1. Downside Protection: Are we confident we are not going to lose money.
2. Median: If we work hard, focus on good business operations, and execute the low-hanging fruit, will be able to grow this business enough to make a solid return (solid return being an increased valuation multiple from a higher revenue base).
3. Upside: If one of our category creation ideas pans out, and we succeeding in winning a very targeted segment of the market, is there an opportunity for this business to be a real winner and provide outsized returns?
Buying and taking on someone else’s business is always a scary proposition — the unknown unknowns — but if you get comfortable with the fundamental of the company, acquisitions can be a real accelerator compared to the epic effort — and high risk — of starting from scratch.