4 Red Flags to Avoid When Acquiring a SaaS Company | SaaS District

Hey guys, welcome back to another video of SaaS District. On today's episode, I'm going to be talking about 4 red flags that you guys should be paying attention to when acquiring a SaaS company. All right, I've made several mistakes in my acquisition journey, and I want to share this with you guys so you don't make the same mistakes and you guys have better success in acquiring a company. So the first thing I look for that you want to quickly avoid when you're looking at a SaaS company is the churn rate. You want to avoid high churn. Okay. And what do I mean by high churn? On average, if you look at a SaaS company, the estimated churn rate where you want to target is look for something less than 5% a month. That's the average churn rate. If you look across all different companies, 5% a month. As you go higher upscale, and I'm talking about SMB-focused SaaS companies, as you go mid-market and enterprise, that should drop, you know, 1%, 2%, 0.5%, even negative churn. But in this situation when you're buying maybe, you know, smaller SaaS companies, look for less than 5% a month, ideally 2 to 4%. Okay, if you find a company between 2 and 4%, You're— you want to move forward with that. That's a good company. Avoid double digits, okay? Double-digit churn is a pain in the ass, okay? I've done this several times. I've worked with companies who have that 10%, 12%, 14%, 15%. It doesn't matter how good your marketing is, okay? You're going to push ahead, you're going to grow, you're going to hit a plateau. There's just no way you can scale it effectively when your churn is that high, okay? Maybe in the first year, of the operations of the business, you might get that 10-15% monthly churn. That's pretty normal because you're still trying to figure out your market. You're still trying to figure out your pricing strategy and, you know, getting market fit. So you're not going to get the ideal clients and know what to focus on. But in this case, you're buying established SaaS companies. Look for, you know, nothing over 6%. Okay. Under 5%. That's my highly recommended first solution and first red flag to avoid. Second thing to look for is the revenue dependency. Is 30% or more of your revenue coming from one client? Is it coming from one channel? Okay. This has happened several times where you lose that client. Okay. 30% of your revenue is gone overnight. Okay. Do you depend on one keyword? Maybe one, you're ranking for one keyword and that drives 30% of your traffic to your page and what's driving user signup. Now, if Google updates their algorithm and you lose the rankings for that keyword, what happens? You start losing that revenue. Okay? So in my situation, I feel that's way too risky. Some people are comfortable going up to 50% and, you know, they mitigate for that risk. Some people, you know, drop that to 20%. I like to have it spread out. I don't like anything over 30%, ideally even less than 10%. So if you have, you know, 100 clients, 1,000 clients, even better. I like it spread out. So if I lose one client, I don't need to worry. I don't lose sleep. And I can continue growing the company every single month. Now, a big point here I want to point out is some people think, yeah, but I can structure an earnout. This has happened before where, you know, say 50% of the revenue comes with one client. And, you know, I'm not going to pay for that upfront. I'm going to pay that over the next few years. And as long as that client, you know, if they decide to cancel and pull out, fine, I didn't pay for that. However, what you're missing here is, and I've made the mistake, is What happens when you lose that client? If you do lose that client and you lose 50% of your revenue, are you able to sustain the company? Okay. If overnight you lose 50%, yeah, you didn't pay that much, but now your company, you're working with a company that's worth half as much. You have half the revenue to work with and maybe you have to fire half the team now. Okay. And that's not a good position to be in. So try to avoid that high dependency on single clients. All right. Going to point number 3, Being owner-dependent, okay? What I mean with that is the business, for example, the sales of the company, is that based completely on the owner's relationships? Is he having one-on-one relationships with, with every single sale? He's full-time involved in the company and the company only grows because of him. Or is it the product? If it's too dependent on the owner or those personal relationships, that's going to disappear the second you take over, or at some point. Because you're no longer the owner running the company? Or is the product development too dependent on the technical founder? Okay. Is the— rather than the code and the documentation and the product itself, is the technical owner the moat? Is he the IP? Okay. And if he leaves, there's no other technical developer that can just come in and pick up and continue building product onto it. You want to avoid those kind of businesses where the product and the business is totally dependent on the owner. Because what you're going to do at that point is you're going to be buying yourself a job. Okay? And that's not the point of investing in SaaS. You guys, people need to think about that. You don't want to come in and have to take over an entire job and buy yourself that full-time role just to be able to sustain it. You want to come in, there's already a system, a business in place, and you can continue to leverage your skills and continue to grow the business while not being tied into specific roles. Last thing to look for, red flag number 4, declining or seasonal revenue. Okay. And what I mean by that is, is the revenue pretty flat? Is the company growing year over year? At least there's some trend of growth, or is it declining? Okay. If you're, if you know it did well at some point and then now it's kind of slowly coming down, down, down, down, down, Or it's seasonal. Maybe they make all their money in Christmas, January, and then for the rest of the year there's no revenue. Or are they just doing, you know, one-time affiliate partnerships where they do these launches and they get a spike of revenue, you know, once a year? So avoid that declining revenue because you're looking at it as a company that's shrinking, that's lost maybe its momentum, that you're going to try to come in there and try to fix it. But you're not— there's no guarantee that you can turn that around. All right. Unless you're coming in and doing a bunch of tests before, or maybe they hire you as a consultant and you can prove that you can turn it around, I wouldn't touch it and be too optimistic. That's a very important point, guys, is don't be too optimistic. You know, a lot of people come in here and they say, yeah, it's declining, but I feel I'm better than the owner and I can easily turn that around because I can just do ABC and it's going to work. But that's not always the case. And when you're doing proper investment in SaaS companies, you have to look at the fundamentals. How is the company doing today? How is the risk today? How is the trends today? And then anything you do above that, then you can look at, you know, getting the upside and, and the, and the growth and, and, you know, the financial reward around that. But in this case, you know, avoid companies that are on the decline. I would personally avoid it even if they're flat. Or there's opportunity for growth, you know, definitely focus on, on the growing companies because you can work on that trend. You can build on that momentum and continue to grow it and take it to the next level. All right guys, so I hope that was helpful. That was the 4 red flags to avoid when you're acquiring a SaaS company. Please make sure to pay attention to these 4: high churn rate, revenue dependency on, you know, 30% plus on one channel or one person, owner-dependent, and declining revenue. Make sure you avoid that. Uh, let me know, guys, from your side, please comment below. What mistakes have you made? What are red flags that you look for when acquiring a SaaS company? Let me know below. And thanks for watching. See you guys on the next episode.