This article is part of our Internet Business Due Diligence series, in which we provide you with information on what makes a particular business model unique when it comes to due diligence. For more in-depth reading on due diligence, see our posts on Due Diligence of an Internet Business and Advanced Due Diligence.

For larger acquisitions, depending on relative size and complexity, due diligence (DD) is likely to be the most lengthy aspect of the business sale process.

It is a crucial step in the transaction as it helps the buyer better understand how the business operates, and confirm key information regarding finances, contracts and customers. The DD process usually begins when the letter of intent (LOI) is signed.

Compared to other online business models, software-as-a-service, commonly known as SaaS, has some unique qualities that prospective buyers should dig into during the due diligence process.

One of the main factors that makes SaaS unique is the level of knowledge required to maintain the application. Ideally, a SaaS owner should have some experience in software development or be able to reliably outsource operations to a trusted developer. There’s also a level of customer support required to run a SaaS business, so the model is less passive than that of most other monetized websites. Understanding the customer base of a recurring revenue business is vital, and churn is typically the metric of greatest use here.

Here are the main SaaS due diligence factors you need to be aware of when considering buying a SaaS business.

SaaS Due Diligence and The Importance of Churn

Churn is an important metric that tells you the number of customers or income flowing in and out of a business on a monthly or annual basis. While every SaaS business is going to have a certain amount of churn, it’s always desirable to have a low churn rate. So, what is a low churn rate? For larger businesses, the consensus is that a healthy churn falls between 6% and 10% annually (or 0.5%-1% monthly) for large to mid-size companies.

Smaller SaaS apps will typically have a higher churn rate, largely because they tend to have other small businesses as clients. In general, SMBs have lower demand and tend to adopt and discontinue services at a higher rate than their larger counterparts. Hence, smaller SaaS apps will have average churn rates of about 31%-58% annually or roughly 3%-7% monthly.

If the business you’re considering has a high churn rate, your next step should be to look at its customer acquisition costs and channels. This will give you an idea of how much it might cost to replace lost users, and whether the current owners are taking advantage of all the channels available to them, such as organic and paid search, affiliate marketing and outbound marketing.

Source Code Review

A premium SaaS business should have well-documented, annotated and tested source code. This is a must-have for investors looking at $500K+ businesses, particularly if they want to scale into seven figures and beyond. Sellers of high-quality businesses will always have good documentation of their source code – if they don’t, it’s a bad sign.

Good documentation is characterized by:

• Readability: Is it simple and concise? How easy will it be for you (or your developers) to use?
• Transparency: Is there version control and numbering?
• Stability: What does the error log look like? How reliable is the code, and is it likely to cause downtime for the business?
• Trustworthiness: Does the code follow a set of guidelines? What standards were used when creating it?

These are just some of the questions you should ask during the due diligence process.

In essence, code should be easily understood. This means it should be straightforward and not contain any superfluous touches. Having DRY code is key to an easy transfer.

Intellectual Property Review

It is necessary to ensure that the intellectual property of the business is watertight. Many business owners actually fail to secure their IP before the sale of their business, and this doesn’t bode well for a new owner.

For a SaaS business, securing IP is a must, especially for transactions that are expected to run above $500K. In an ideal situation, a business owner would have pursued IP in the early stages of the business, though there generally aren’t any drawbacks to retroactively applying for a trademark before the sale of the business. This can be done through the United States Patent and Trademark Office, though you should be aware that trademarks tend to be easier and less expensive to obtain than patents.

Any programmer that was involved in developing the product should also sign an IP assignment for the work they have completed. This also applies to contractors, freelancers or third-party companies. Though this is most pertinent to sales larger than $500K, it is worth securing IP at the outset of a business, regardless of its size.

Learn more about how How to Acquire a Business as A First Time Buyer from one of FE International’s buyers, Michael Frew.

Customer Support

Many SaaS businesses live and die by customer support, so a heavy review of the customer support function is an integral part of the due diligence process. This means going through help desk or ticketing systems (such as Help Scout) and checking average response time, resolution rate and customer satisfaction.

All of this data will also be weighed against the overall difficulty of the questions customers are asking. If all of the questions can be answered within five to 10 minutes using an internal wiki, it means that the customer support process is relatively simple and well-optimized. On the other hand, if questions require an average of 60 minutes or more to answer, and are highly technical in nature, this means you’ll need both the time and expertise to pick up where the previous owner left off.

Read more about Due Diligence of an Internet Business: 6 Things to Vet

What Due Diligence Factors Don’t Apply to SaaS?

Depending on the size of the niche and a business’ current user base, some metrics like pageviews and click-through rate won’t be as relevant to a SaaS operation when compared to advertising or e-commerce. In fact, a solid, scalable product with low web traffic could be an attractive opportunity for you, as it would be an easy, inexpensive fix to drive traffic to the site and, in turn, expand the user base.

Conclusion

With a SaaS business, it is essential to evaluate churn, the source code, intellectual property and the customer support history. You might be looking at a high price tag to acquire the business, so you’ll want to do everything you can to ensure that you’ll not just make your money back, but continue to grow revenue and make profit.

Our blog post on SaaS metrics takes a deep dive into how this business model is valued. We leverage our experience and insights from hundreds of our SaaS sales to take a deep dive into valuation and salability.