Due diligence: What you need to know

Due diligence is a thorough review of the different aspects of a company to ensure that the company is in good order and according to the buyer’s expectations. As investors, we always use due diligence before making the final investment decision.

Due diligence of a Software-as-a-Service (SaaS) company is all about identifying risks and potential – it enables the buyer to gain a comprehensive understanding of the business about to be acquired. The due diligence process involves investigating a company’s commercial, financial, legal, technical, and organizational aspects and often requires assistance from third-party advisors. In this article, we will cover the main aspects of the due diligence process of a Business-To-Business (B2B) SaaS company and what you should prepare for when either being acquired or acquiring a company.

Written by: Eirik Hjelmeland, Investment Manager at Viking Venture

Commercial due diligence

Commercial due diligence (“CDD”) involves a broad range of topics and explores a company’s external and internal commercial positioning.

The external investigation covers the market, including size, growth, drivers, and the competitive landscape. These analyses are important for understanding market dynamics, competitive intensity, and the likelihood of future success. Key questions include expectations for growth among existing customers, whether any regulations will impact the market, what percentage of potential customers already have a solution, how tough the competition is for new customers, and the company’s competitive advantages. The focus is on mapping out risks and potential upside.

The internal investigation focuses on analyzing the company’s capabilities. We spend much time understanding the efficiency and maturity of the company’s sales processes. As stated in several articles and webinars, it is crucial to understand the scalability of the sales engine. Hiring more sales and marketing reps is a waste of money if it doesn’t scale. This work stream also involves an analysis of the company’s general operational efficiency and understanding of the composition of the customer base as well as development and characteristics.

Customer interviews form a critical workstream in the commercial due diligence. At Viking Venture, we always conduct 20 to 25 customer interviews as part of our commercial due diligence. This is the best way to understand how good a company’s software really is. What the management says during the product demo is one thing, but the real insight lies with the customers. Customer interviews also provide important input to the market and competitor analyses.

Financial due diligence

The primary goal of financial due diligence (“FDD”) of a company is to confirm the financial figures while also investigating the company’s financial health. Although we do not provide an exhaustive list of all FDD workstreams and analyses in this article, we will highlight the most important ones.

One important aspect of the FDD is understanding the cost base and underlying cash generation to ensure scalability. However, the main topic in our FDDs is ensuring we have complete control of the Annual Recurring Revenue (ARR) figures (see our article about ARR here). This step involves confirming the ARR by analyzing customer contracts and understanding the historical development of the ARR base. As the ARR is not subject to audit (contrary to the P&L and the balance sheet) and some companies tend not to understand it fully, confirming the accuracy of ARR figures and related KPIs is very important. If you have read our valuation and SaaS KPIs articles, you know that the ARR and related KPIs are the most important valuation drivers.

Engaging a third-party advisor to assist in the FDD is common practice. An advisor can provide both capacity and competence as the advisors often are large consultancies with in-house audit capabilities.

Legal due diligence

Legal due diligence (“LDD”) investigates a company’s legal affairs to ensure compliance and mitigate risks. Moreover, necessary LDD analyses include:

• Reviewing the customer contracts to identify potential liabilities or obligations as well as terms for payment, renewal, and price adjustments.
• Ensuring ownership of all intellectual property rights and compliance with open-source licensing terms.
• Compliance with GDPR and other privacy laws and regulations.

The LDD is, in most cases, conducted by a team of lawyers as it requires legal expertise. As laws and regulations vary between countries, using local lawyers is recommended.

Organizational due diligence

The organizational due diligence is an assessment of the management team and the management structure of the company. People are one of the most important assets within any company. Ensuring that we have the right team in place and that the team is working together in a professional and efficient way is an essential aspect of due diligence. We do this by interviewing management team members separately and jointly. These interviews aim to uncover any underlying conflicts or issues, contributing to identifying and mitigating risks. At the same time, we get a good understanding of where the organization is strong and where there are gaps to be filled.

Technical due diligence

Technical due diligence is an assessment of the company’s software product including competence, processes, quality assessment, use of tools, security, and operational framework. The purpose is to assess whether the software is scalable, mature, and future-proof or in need of a large investment. Both in terms of time and money to serve customers well. The product is typically the largest investment made in the early years of a company. Thus, a substantial part of the company value when we invest. A rewrite of the software code to make the product scalable will be time-consuming and costly. A change of operations environment might lead to increased operational costs reducing future profitability and requiring more cash than anticipated by management and the investor.

Techical due diligence is normally conducted by an outside team specializing in such assessments.

Conclusion

The main purpose of this article is to provide an introduction to due diligence of a B2B SaaS company. As well as what you, as a potential acquirer or acquisition target, should prepare for. As a follow-up, we will delve into each due diligence workstreams and provide a complete checklist of topics and analyses.