10 Key Due Diligence Risks in a Private Equity start-up investment
In this article we detail 10 due diligence risks to look for before investing your capital in or acquiring a private business. Why? Because as an investor, it is fundamental to have a strong understanding of what you are buying into. In the private equity and start-up space, public information is not available, thus the capacity of advisors or investors to find clues indicating how strong a private business is during the financial due diligence phase is a crucial element in making educated investment decisions.
Equity investment in a specific industry or niche means you are likely to develop certain reflexes and may conduct a set of due diligence procedures that may be very specific to your area of focus.
In my role as an investment manager at HoriZen Capital, a private equity firm focusing on the micro Software as a Service (SaaS) market, we use a set of key metrics that are always requested at the beginning of our financial due diligence process: Customer Lifetime Value (CLTV), Churn rate and Customer Acquisition Cost (CAC).
The aforementioned metrics are key for evaluating SaaS companies our way, however there are general metrics of financial analyses that apply to any business, startup, established small business, large Enterprise, SaaS or not SaaS model..
Why is financial due diligence (FDD) so important?
FDD represents a substantial amount of the work and analyses a professional investor will conduct to gain a better understanding of the robustness of a company. Analysing the financials and business operations identifies areas of risk which can directly influence the potential valuation offered and allows a deep understanding of the asset being invested into.
Relying solely on annual financial statements or summarized financial decks is never enough. Private Equity and M&A Experience will also teach you that the devil is in the details and reviewing financial statements at face value will give you a partial view, thus partial understanding of what is really happening in a company.
Going through the financial due diligence process to buy safely requires the ability and knowledge to look for exhaustive information on strategic areas that are key drivers in the investment decision and being able to process this information and look for red flags and signs that will help you depict a fair picture of the risk profile of the business.
What qualifies as a “red flag”
Red flags, be it just one or several, generally reveal themselves during the due diligence process and can be hugely influential in providing major risk indicators of potential failure or downside post-acquisition or investment signs. A common red flag for SaaS companies is a high customer count churning every month, even if the figures are counterbalanced by new clients. What can be even worse for a SaaS company is not being unable to retain customers for more than a couple of months — crippling the lifetime revenue a customer can bring. Have those two red flags and it can indicate that the product is not delivering value, the market may be too competitive or even operational weaknesses in the business practices of the company. Whatever the actual reasons, such indicators can give you a fair warning of the difficulties the company is currently facing and what can be done to cope post-acquisition. A red flag may not necessarily be a deal-breaker but several, mixed with accounting figures that don’t paint the best picture may be enough to tip the scales. There may be a good reason behind a particular red flag and it should be viewed as an invitation for any private equity investor or buyer to do further, more exhaustive due diligence on the matter and potentially de-risk their investment decisions by offering a deal structure with more protection, be it through an earn-out mechanism, seller equity retention, holdback period or even introducing convertible debt instead of straight equity.
The Most Common Red Flags and Risks in Private Equity
Red flag 1 — No Clear Reason for Selling
We have all encountered an offer that sounds too good to be true, where we get conflicted emotion on what our gut feeling tells us. There could be or even must be something wrong with the situation at hand, however we’re still insatiably drawn to exploring it when it happens, driven by fear of missing out or the excitement of what’s on offer. Call it animal spirits, sentiment, the devil or angel on the shoulder, we all at times fight a natural inclination to act on our emotions . Private equity investors are no exception to this at all.
Before getting lost in the spreadsheets,PDfs and emails, it is wise to take a step back, try to put yourself in the seller’s shoes and ask yourself a simple question: Why are you selling? There may not be a straight right answer, even if there can absolutely be some wrong ones. The seller may easily come up with a prepared decent response but what you really want is a reason that is consistent and matches with the other information gathered before the deal takes place. For instance, a seller may say they are looking to sell for health reasons, but you learn along the way that they are actually working on a new venture, which tells you why certain red flags are appearing, their attention has turned and there may be a different agenda behind the current proposed sale.
A very common selling reason we see amongst small business owners is they “haven’t been involved in the business lately”, often pointing towards a decline in sales. Sometimes they “have not really focused or invested in sales recently”. While that may be true and perhaps be a good opportunity for a buyer to step in and turn the business into a successful venture, often there could be missed out crucial details. In our line of work, in Private Equity investment, we take extra measures to ensure we understand the actual involvement of the business owner yesterday, today and even their motive should they stay post acquisition.
Truly assessing what has been done in the past to try and sell the product, the efforts of the owners and the current strategy can provide a clear indication of underlying motives and the strengths and weaknesses the business has. A business claiming that they never really tried to sell their product does not sound very rational, it’s more likely that what’s been tried was not successful, may need tweaking or might never get going at all. This is not necessarily a dead breaker, but it does mean as an investor that you need to understand what failed in the past and see if there is a better alternative to ensure the success of the business.
Red flag 2 — Declining Revenue
A lot of private companies listed on broker marketplaces initially look like good private equity investments. However, as soon as we receive financials, often we are disappointed to see that sales have been declining. The first indication is that the seller may be trying to get rid of a declining business. Often this is more true with young start-ups or internet businesses less than 3 year old. A younger business can also represent an even higher risk than a similar older business because the product or the company may have benefitted from a short-lived peak during a ramp up. They may have had really good free PR exposure at launch, or have had a peak of early adopters but the recent decline in sales are a sign that the model is not sustainable.
Red flag 3 — High Customer Concentration
Analysing customer importance as per the table above allows you to easily understand how big the top customers are relative to total revenue. Being too reliant on a few customers may be normal at first, but longer term this can represent a huge risk going forward as the loss of one can have a significant impact on the bottom line of your business.
As a rule of thumb, at HoriZen Capital, we generally use 10% or more of sales as the threshold for a significant customer to make up as part of the revenue of the business. With a high customer concentration, it is important in your due diligence process to understand the state of the relationship between the company, contracts signed/ commitments for each. Again, having a few large main customers is not necessarily a bad thing if customers are highly captive and have been with the business for years. Sticky customers can provide a strong certainty of future cash inflow.
Dependency on the current owner relationship is another key aspect. If you are considering acquiring a small company and replacing senior management, you need to make sure you will retain that relationship going forward. An earn-out mechanism based on the guarantee that these main customers will stay with the business post-acquisition can help you mitigate the risk of seeing them jump ship.
Red flag 4 — Poor Sales Pipeline
Strong historical revenue and growth are obvious good signs of business strength. However, as an investor you are investing and believing in the future value of the company. One of the best clues you can assess is from looking at the current sales pipeline. If it shows a lack of current advanced conversations, poor understanding of potential customers, key metrics and numbers forward pacing company revenues then it certainly undermines the growth assumption of the management team. Ideally part of your due-diligence is to view the current pipeline at different dates in the past to understand how it evolved and correlate with historical sales.
One way to rationalize the pipeline analysis and come up with an estimated number of short term future sales is to apply a probability % of closing a contract based on the stage each lead is at. These probabilities may already be used by management as part of their own pipeline assessment but you can also easily use a rule of thumb based on your own knowledge of the market or using historical conversion rates of the target. Evaluating best and worst case scenarios can provide further insight into the product-market fit, pipeline velocity, onboarding and many other areas of business development.
Red flag 5 — High Revenue Seasonality
High revenue seasonality can represent a significant threat for a private equity investor if most of the company’s revenue is generated over a short period. It multiplies the impact on the whole year financial results if anything goes wrong during the high season period. Aside from cash flow issues, seasonality can also lead to more complex operations and a harder budgeting process, hurting businesses by making them less agile if market conditions suddenly change. A perfect illustration are retail businesses, who need to build up inventory over the September — November season in expectation of the Christmas peak in sales.
From a private equity investment perspective a highly seasonal business may pose a challenge in getting comfort around the estimated short term financial results of the target post-acquisition. If the M&A transaction or the investment occurs a few months after the peak sales season, it is very hard for investors to find clues on how the business will be doing at the next sales peak season, especially if the market is particularly competitive or the company is young. One obvious solution to mitigate that risk is for the investor to wait and engage in a financial operation at a more appropriate time or when the business matures further.
Red flag 6 — High Level of One-Off Revenue
When we look at a new investment opportunity, we want to understand the nitty gritty of the revenue. Revenue breakdown by type of customer, by geography, by channel etc. The difference between one-off and recurring will often be a crucial point which can be easily overlooked. It is especially important in the case of running on a Software As A Service or a subscription model. Recurring revenue provides the buyer with a good comfort around revenue generation for the years post-transaction if churn rate is reasonable. However one-off revenue offer no guarantee that the company will continue to generate sales post-transaction, hence increasing the risk for a buyer.
The graph above shows a perfect example of a company showing increasing revenue at the consolidated level, however the breakdown between recurring and non recurring clearly shows that the recurring sales are declining. If one-off sales were abnormally high in FY20 and revert back to FY19 levels next year, buyer would take a severe hit post-transaction. On top of that, missing that point would mean missing the chance to understand why the recurring revenue are on the decline, potentially uncovering an issue with the product or a change in the market.
Red flag 7 — Increase or Decrease in Marketing Spend in the Last Few Months
This red flag is one of the most common that we see with small businesses. Flagging a recent increase or decrease in marketing spend in the last few months is even more critical with SaaS businesses as digital marketing is often one of the pillars that sustains the growth and scalability of a SaaS business. We often see, and most particularly with business owners who have been preparing for a sale are either:
1- Recent increase in marketing spend to increase the revenue and hope to get a higher valuation / higher valuation multiple. One may argue that it is rather a positive sign if management recently increased marketing and that it resulted in an increase in sales. But this will depend on what type of marketing. To sustainably create value, it is important to create a digital marketing ecosystem which is consistent and robust and will create durable, robust inbound interest and predictable revenue.
On the other hand, a quick and dirty marketing campaign such as an affiliate marketing launch, may lead to a short-lived spike in traffic or users that may depict a temporary better illusion of the company pre-acquisition but may not be sustainable in the long term. The campaign may have also boosted revenue but had a negative impact on the profitability. This can be spotted by analysing monthly financials but may also be a bit tricky to correctly estimate due to the delay between marketing spend and its delayed impact on revenue.
2- Recent decrease in marketing spend to increase short term profitability and cash available before transaction. This red flag can be easily spotted by looking at individual monthly accounts. This is a bad sign as the sustainability of sales going forward often relies heavily on regular marketing expenses. Cutting off these expenses will likely have an impact on the longer term company’s growth especially for young businesses.
Red flag 8 — Business and Sales Heavily Reliant on Owner’s Network
When we deal with start-ups or small SaaS businesses, the company’s founder is often essential to the business. When investing through cash injection and retaining the existing team, it may not be an issue. However, when buying out an existing founder, it is crucial to understand how much the business is reliant on the seller. From a technology perspective the founder may have developed the back-end themselves, however we believe you can always find highly competent engineers to take over, as long as the seller agrees to a transition period to pass on their knowledge.
However, when it comes to business relationships and sales, if all the revenue has been generated through the seller’s personal and professional network you need to be extra careful on your capacity to retain existing customers and to continue fuelling the growth as a potential buyer. In such cases and even more so than usual, it will be necessary for the seller to sign a strong and exhaustive anti-compete agreement..
Red flag 9 — High employee turnover
One of the best indicators of internal operational efficiency is to look at how long employees stay within the company. There can be many reasons why employees leave (stressful job, bad pay, bad management etc) but they all point to the same reality: there is something going on that should be fixed. Conducting interviews with individual employees in your advanced due diligence process and looking up Glassdoor reviews can be invaluable to get a better understanding of the situation and give you enough information to figure out if you think you can remedy the problem or if this is a deal breaker.
Red flag 10 — Aging Receivables
Trade receivable ageing analysis corresponds to how long any given receivable has been outstanding i.e. how much time an outstanding invoice has been left unpaid as of today. This allows investors to better understand the cash management cycle but also to uncover potential unrecognized bad debt. With start-ups or small businesses it is common that accounting procedures are not all well implemented.
Often small companies recognize bad debts only at fiscal year-end, meaning that bad debts are not yet reflected mid year. Spotting an unusually high amount of old receivables can potentially uncover a customer loss or an ongoing litigation that as a private equity investor you would very much like to be aware of before committing any money to the business.
We recommend looking at trade receivable ageing for several past dates to understand if there is a trend of customers taking longer to pay. This analysis can also be done at the Net Working Capital level by calculating monthly DSO (Days of Sales Outstanding) which reflect on a monthly basis on average how many days customers take before paying invoiced amounts.
Do your Homework, Dig in and Don’t Buy What You Don’t Understand
We’ve presented ten of the most common red flags and risks that we come across when assessing whether or not we want to invest in a SaaS startup. In reality, there are many others and some are far from obvious. If you are investing on your own, we recommend to take the time to fully understand the business you are considering buying into.
If you feel like you are not totally comfortable doing all this research on your own, hire a professional to assist you in your due diligence, or learn how to do Financial Due Diligence! The worst thing to do really is to invest too hastily in a business that later uncovers some massive flaws that could have been spotted early on. Reasonable investing is not about completely avoiding risk, it’s all about understanding it and making more educated decisions.