8 Red Flags to Beware of When Doing Due Diligence on a SaaS Startup

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Originally Posted On: https://resources.microacquire.com/8-red-flags-to-beware-of-when-doing-due-diligence-on-a-saas-startup/

Due diligence might set alarm bells ringing. Spot issues early with our tips below.

To buy a house, do you stick a pin in property listings and hope for the best? No, you find the right size, style, and location. You walk the surroundings, speak to the current owners, and check out the value of other houses sold in the area. Then you get a surveyor’s report to verify the property is in a good state of repair. Only then might you make an offer.

Now, acquiring a SaaS startup isn’t exactly like buying a house, but there are similarities. One is due diligence, the process of verifying that all is what it seems, that the startup is truly worth its asking price, and there are no skeletons waiting to tumble out of the closet. Without proper due diligence, you risk acquiring a dud that fails the moment it changes hands.

Let’s face it: all entrepreneurs want to exit at high valuations. While there are thousands of great startups out there, not all of them will be as promising as they look on paper. Much like a “cozy apartment next to local transport links” might be code for a glorified closet under a railway line, you must also be aware of the red flags in due diligence that point to a disaster in disguise.

We do business with people we like. If you like the look of a startup but the founder is a pain to deal with, it might be best to walk away. While some startups are worth suffering a cantankerous founder, they are rare. In most cases, a troublesome founder leads to a troublesome acquisition. You need mutual respect and admiration if you want to make the acquisition work.

Remember: acquiring a startup is a collaboration between you and the founder. If you’re always chasing responses and parrying unreasonable demands, you might be heading into a perfect storm that blows your entrepreneurial ambitions off course. Instead, do due diligence on the founder’s attitude as well as their startup to ensure calm seas ahead.

Yes, the acquisition process is complex, and due diligence a gargantuan task. Nevertheless, there’s a bounty of educational content on the internet – mostly free – with which to prepare for acquisition, regardless of size. If the founder of the startup you’re acquiring enters this process with zero prior knowledge, this is a red flag. A sign that they’re not uninformed, but lazy.

While pertinent questions are welcome, lessons should be avoided. You’re not teaching an acquisition but performing one and your partner (the founder) should’ve rehearsed their steps. Google “How do acquisitions work?” and it returns over 86 million results. Not all of those will be helpful or relevant, of course, but the fact there are millions of acquisition resources (including our own) means there’s no excuse for being ill-prepared.

The founder has the right to keep sensitive intellectual property or other company data private during an acquisition. At least until they’re certain the deal will close. However, you must strike a balance between respecting their wishes and de-rising the acquisition. It comes down to what’s reasonable to disclose, which is subjective (to an extent) and must be agreed in advance.

A founder that refuses, point blank, to a reasonable request for information might be hiding something. At the very least, you should be able to view financial data (the founder can link Stripe, ChartMogul, and other metrics tools within MicroAcquire) that supports the valuation and growth projections. You might also suggest signing an NDA to overcome any reticence.

The perfect startup doesn’t exist. Every startup, no matter how successful, has problems. Evaluating these problems is the purpose of due diligence. The old adage, “too good to be true” is a faithful guide when reviewing everything the founder submits. Not only does perfect data indicate possible misrepresentation, but it might also indicate missing information (see #3).

The founder might not intentionally misrepresent their startup. It might simply be ignorance, which is a lot easier to forgive that deceit. Nevertheless, a startup without a single flaw hides a dirty secret somewhere and you can either find it or abandon the acquisition entirely. Revealing something the founder wasn’t aware of might give you the edge in final negotiations.

You learn a lot about a startup from its team. A happy, motivated team symbolizes a harmonious startup with a positive company culture and supportive leadership. Such a team might be worth the acquisition alone, especially if you prize their skills and experience. However, a demotivated, unhappy team is symptomatic of dysfunction and neglect – and negativity breeds like termites.

Nevertheless, an acquisition is a fresh start and you might be the change the startup needs. The question is: do you want to acquire a fixer-upper? All else being equal, you might have a job convincing team members to stay on, and if they do, fixing whatever’s wrong could be a considerable cost in time, money, or resources. Do so only if you’re prepared for it.

Unhappy customers aren’t the end of the world. In fact, you might use this to your advantage by making them happy and catalyzing growth. The question is why they’re unhappy, and for how long they’ve been suffering. Is it pricing, service, product, or something else? Red flags here depend on what you can or are willing to fix post-acquisition.

If the founder has been overcharging, for example, this could devalue the acquisition if it means reducing prices to achieve growth. You might need to hire support teams or switch CRM platforms to fix service issues, which again adds cost, and product problems will require time and resources. Offset these anticipated costs when negotiating the purchase price.

When you lift the lid on the startup’s tech stack, you don’t want to find it crawling with bugs. Not only do they cause unexpected behavior, making product development harder, they also introduce security vulnerabilities which are difficult to isolate and repair without the help of third-party tools. Sometimes it’s better to abandon compromised code and start afresh.

While bugs are de facto for SaaS, severely hampered code is a red flag. Founders who lack technical expertise will outsource development to contractors, which can result in a mish-mash of conflicting approaches and, potentially, ownership disputes. It might also signify complacency, which begs the question where else the founder has cut corners.

When you acquire a startup, not everything survives the transfer. Employees might leave, vendors might cut ties, and there’s always the risk of higher churn while you adjust to the nuances of the business. But if you’re heavily relying on a partnership, whether it’s a high-worth client or a critical service provider, ensure you check the contracts are transferable.

It pays to be cynical here and assume you need permission from all third parties the startup currently employs the services of before you acquire. Otherwise, you risk leaving with less than you need to run the business, and the founder might have enough to continue as a going concern – meaning you’ve acquired both a startup and a competitor!

Founders are seldom out to trick buyers. Yes, you might find a bad egg or two, but they’re easy to spot: they might be evasive under questioning or overconfident and bullish. Nevertheless, you’ll find many who’re helpful and collaborative, too. Use the red flags above to help you distinguish between them.

Learn more about how to de-risk acquisitions on our resources page.