One of the best ways to keep up with the latest M&A trends and build a strategy that ensures success is to follow the latest market research. The recently published SaaS CEO Search Fund Survey provides valuable insights into the changing landscape of search funds in small business M&A. It compares pre-2019 and post-2019 cohorts and identifies trends that potential buyers can leverage to inform their M&A strategies across verticals.
Search funds have been in existence for nearly four decades, and the business landscape has changed significantly since their inception. Although searchers have historically participated in acquisitions across a broad range of industries, the software industry has consistently been a popular and highly sought-after sector among potential buyers. Software as a Service (SaaS) is especially attractive to search funds due to its recurring revenue operating model and significant profit potential.
In this article, we analyze some of these trends and also offer actionable insights for searchers, regardless of the domain.
The Role of Revenue-Based Valuation and Growth Potential
The search fund survey highlights a shift towards revenue-based valuation methods for SaaS companies since 2019, resulting in higher valuations. This can be appropriate for high growth SaaS companies that experience low profit margins early in their life cycles but become valuable businesses as they scale and unit economics improve. The study also revealed that most SaaS companies acquired by search funds were either unaware of or unable to accurately measure their LTV/CAC ratio, a crucial metric for evaluating the cost-effectiveness of customer acquisition, possibly due to the shorter operating history of the companies being acquired. However, based on data from companies with reported LTV/CAC ratios, acquisitions made after 2019 tended to have stronger unit economics, with a higher proportion of companies reporting LTV/CAC ratios of 5x or greater. Our take on this is that accurately measuring the LTV/CAC ratio is vital for assessing the unit economics and overall health of a SaaS business and should be a critical consideration during the due diligence process.
Since 2019, the quality of company revenue has improved, with recurring revenue increasing as a percentage of total revenue relative to pre-2019 acquisitions. This is potentially due to a shift from perpetual-use pricing models to subscription-based pricing models. This trend is crucial for SMB searchers to consider, as buyers increasingly seek businesses with recurring revenue or subscriptions.
One industry-specific term highlighted in the search fund survey is “The Rule of 40,” a popular metric for measuring the success of SaaS companies. This principle suggests that the combined revenue growth rate and profit margin should be equal to or exceed 40%. According to the survey, companies purchased after 2019 were more likely to meet this rule, mainly due to high revenue growth.
However, when it comes to evaluating non-SaaS companies in the context of small businesses, the Rule of 40 may not always be appropriate, as such businesses can have different growth rates and profit margins compared to larger or technology-focused firms. Instead, it is better to consider the specific industry, growth potential, and unique characteristics of the companies involved.
For SaaS companies, ensuring product quality is crucial for healthy revenue growth. CEOs of pre-2019 acquisitions were more likely to report unsatisfactory code base and technical debt, while CEOs of post-2019 acquisitions were typically content with their products, an observation that correlates with stronger revenue metrics for post-2019 acquisitions. This highlights the importance of thorough due diligence for small business buyers to assess the product and/or service, as this can have a significant impact on the success of the acquisition.
The Importance of Customer Concentration and Acquisition
Despite faster growth, the study revealed that post-2019 acquisitions were more likely to have a higher customer concentration and more likely to have taken on leverage to support their stronger products and higher growth rates. This finding carries significant implications for SMB acquisitions, as these higher growth companies may come with greater risks. While the shift in the risk profile between the two cohorts was notable, the study discovered that most target companies in both cohorts exhibited low levels of customer concentration, with their most substantial customers accounting for only 0% to 5% of total revenue.
Some Common Initial Pitfalls and How to Offset Them
The search fund survey found that a surprisingly large number of companies required funding beyond day-to-day working capital requirements to be added to the balance sheet at closing. Regardless of the industry, it is important for small business buyers to be aware of this reality: funding additional cash to the balance sheet at closing beyond day-to-day working capital requirements can be more common than expected, particularly for post-2019 acquisitions. This should be taken into account when determining the acquisition price and developing an overall financial strategy.
What also caught our eye was the fact that a majority of companies experienced a decline in their EBITDA margins. However, acquisitions made post-2019 were more likely to have flat or increased margins. Regarding the Opex spend, it was primarily allocated towards addressing product-related issues and investments in sales and marketing for companies that experienced a decline in margins post-acquisition. Pre-2019 acquisitions were more likely to attribute margin declines to product considerations.
What we can learn from here is that search funds should account for potential margin contraction post-close as it is a common occurrence in the early years following an acquisition. This contraction can be attributed to factors such as investments in product development, sales and marketing, and historical underinvestment.
The rate of revenue growth post-acquisition was similar for both time cohorts, with the majority reporting a prioritization of higher revenue growth rates. This finding highlights the importance of revenue growth as a key value creation lever for small business acquisitions. In contrast, leverage was found to be the least important factor. As such, prospective acquirers should prioritize companies with strong products, large total addressable markets (TAM), and truly recurring revenue streams.
Another takeaway from the study is that investing early in experienced leadership for key areas such as management, sales, and operations can yield significant benefits post-acquisition for both SaaS and SMB acquisitions.
Search Fund Survey Conclusion
Since 2019, search funds looking in the SaaS space have shown a preference for companies that possess revenue-based valuations, larger revenue bases, and higher growth rates compared to other types of businesses. This trend may be attributed to a shift in customer preferences towards subscription-based services, as companies with a higher proportion of recurring revenue to total revenue have become increasingly attractive to search funds. Additionally, post-2019 acquisitions of SaaS companies by search funds have typically involved larger businesses with more recurring revenue, albeit with a higher reliance on debt financing to fund the deals.
Broadly, the SaaS companies in the post-2019 cohort resembled venture-style tech companies more closely than they did the traditional, consistent SMB acquisition we typically attribute to the search fund model. This shows the expansion of our industry, one that we expect will continue as additional entrepreneurs look to acquire companies themselves.