Diamond Innabi - SaaS M&A 101: Selling Your Software Company

Speaker A: Foreign.

Speaker B: The Cloud Returns podcast covers all types of software investing, whether seed, venture capital, growth, equity, private equity, debt, and even the public markets. All right, I'm, um, pleased to have Diamond Inabi from Software Equity Group. They're a boutique. I've long consumed their content. They're also based in San Diego, so I have some bias towards them and wanted to get them on the show. And she's, uh, made some time for us. So do you want to tell us a little bit more about yourself and your firm?

Speaker A: Yeah, absolutely. And thank you for having me. My name is Diamond Inabi and I'm a principal with SCG. I've been with SCG for about 10 years now. And like you mentioned, SCG is a boutique M and a advisory firm, and we're based at out of San Diego. We focus exclusively on Software and SaaS companies, and we have some presence across the U.S. i'm actually calling from Miami, so I lead our east coast presence, but the majority of our firm is in San Diego. Ah.

Speaker B: Uh, I was not aware of the Miami dynamic expanded.

Speaker A: Yeah, we picked probably the two best places in the US to be, so that is true.

Speaker B: Well, you know, with some of this, we like to just go through, like the 101 type content. Uh, you could have a, just a general theoretical sense of what it means to sell your software company. But if you're a founder here, listening and thinking through options, or just want to have a general sense, like what exactly goes into it, like setting up a data room, legal preparation, like, what's the timeline? How many parties do you interact with? Like, kind of like the next level of like, what actually happens to get to the finish line?

Speaker A: Yeah, absolutely. And it's a good question because I think a lot of people fail to realize how much work actually goes into a process. And I'll just talk about how SEG runs processes, because I think that will be helpful context. So the way we run processes, it's very methodical. It's been a process that has been built over many years. A lot of experience and domain expertise built into it. But you can run different types of processes. So you can run a process that's anywhere from two to three months, which is something like a direct negotiation. Right. You have a buyer investor that's coming to you. You don't want to do a broad market outreach. You just want to negotiate with no one. And you're setting up a data room, having that buyer do their diligence, uh, and that's it. Trying to close a deal. What SEG Typically, and most of our processes are six to seven months, which is what we would consider a broad process. And the reason why we tend to like these processes for our clients is because it really drives that competitive tension and valuations. And in a broad type process, there's usually a two stage bidding process. So I would say for the first six to eight weeks, it's really the opportunity to get your materials together. If you're working with a banker like SCG or we're trying to learn your business, we're trying to do our own diligence on your business to really ensure that we have a good grasp and we're well prepared for anything that would happen or requests that are happening when we're actually in market. So putting together a confidential information memorandum, which is basically a deck that goes into all the details about the business, putting together a forecast, putting together a customer analysis, a financial package, everything, and all the things that a buyer investor will want to see when we actually go talk to them. When that stage is done, you move into what is called a pre IOI phase, which is when you actually start your market outreach. You talk to the buyer universe, you're getting them excited and getting them to want to submit an offer. And that's when you get to the end of that stage, which is these parties submitting an indication of interest, which we call an ioi. From there with our clients, we're working with them to decide who we actually want to move on to the second stage of the process. And we're bringing down that group to the pre loi stage. And here is really again the opportunity to build even more excitement de risk the process, provide a lot of information to parties, facilitate conversations and drive that competitive tension. So, so when we get to the end of that process, when these parties are submitting an offer, the letter of intent, which is hopefully their best and final, you know, we are able to determine what work has been done, the terms of the offer, the valuation of the offer, negotiate a bit and bring it down to, you know, one or two parties that we want to move into the diligence phase. And when we get to that diligence phase, it's really, you know, confirmatory rather than exploratory because of all the work that we've done in the prior, let's say seven months and really with the intention of getting a deal done at the price and terms that they went into the diligence process with. So that's kind of a banked process, but that's, it's a lot of work that goes into that six to seven months to really ensure that you're getting the best price for your business and also providing all the material that you know, a party will want to see from, um, you know, when we first talk to them, all the way through

Speaker B: diligence, uh, and what have you seen from sellers in terms of even preparing before this process? Like when do sophisticated CEOs start interfacing with SEG or deciding on an M, M and A path? Is it three years in advance, is it 18 months in advance?

Speaker A: It's a great question because it differs so widely. So occasionally we'll get the founder, as you would say, come to us and say I'm ready to run a process in the next three to six months, let's get going. And we get going. I would say the majority of the time they're coming to us, you know, one to two years in advance, maybe even longer, and saying what can I do to best prepare myself and my business for a market launch? And that's really our opportunity to, you know, help them along the way, give them advice, tell them where we see some perceived weaknesses or risks and where they're really, uh, you know, strong and help them get to the point where they're ultimately ready to go to market. Occasionally we'll have those cases where you know, we're building that relationship over 10 years which has happened and those are honestly great because we're able to help the business along the way, provide that advice. And when that founder or CEO is ready to go, we know the business really well, we know where they've improved over time and then they're ultimately ready to go to market.

Speaker B: And what are some mistakes like founders, CEOs boards make when it comes to M and A, like that they, they go to market without having a sufficient uh, executive bench or they actually haven't made real traction on that growth initiative that you're selling. But there's no tangible, you know, evidence to support, you know, a credible forecast that's going to take off. So those are just some examples I was theorizing on. Like what are some real mistakes that you see, you know, kind of happen again and again?

Speaker A: Mhm. This is going to be extremely self serving but it's very important to consult with experts, whether that's an M and a advisor or an accountant or legal. Oftentimes where we see founders, you know, making a mistake when they're not engaged with someone is that they're caught flat footed when they're in market. They don't know what they need to present, they don't know how to position their business, they don't know what, you know, the buyer and investor community want to see. So I'll start with that. But outside of that, there are a few things that I would focus on as a seller. Number one is really understanding your, your product and making sure that you know, whatever updates you're doing, if you're doing rewrites, whatever it is that you're focusing on, the quality, the mission criticality and the differentiation of your product, you could have the best product in the world, but if it's not differentiated from competitors, that's going to be a real struggle in the market. And there's a lot of ways that you can do that. And you know, with that you're making sure that your customers are happy. So focusing on customer support, ensuring that, you know, if there is a downturn in the market, that your product isn't the first to go out the door with budget cuts. So I would start with product and making sure that you have a really strong base in product. And to your point, you know, if you have some product initiatives, that those are being prioritized because if you do have a lot of technical debt, if you're falling behind the competition, that's going to be a real issue when you go to market. The other thing is really knowing your numbers and knowing how to speak to your numbers and knowing them like the back of your hand. So buyers and investors are really going to analyze with a lot of uh, scrutiny to all your KPIs, your error trends, your retention, your customer acquisition costs, your ebitda, your gross margins and making sure that they're actually calculated correctly. Oftentimes we'll see people come to us and they, they have all their KPIs together, which is great. But then we look deeper into maybe their gross margins and we find out, hey, you know, you're missing this expense which the buyer investor community, the market actually is including in that analysis and you're not. So it changes things. And then the last thing I'll talk about is just having really strong business fundamentals. You mentioned a little bit of that. And the reason for this is when buyers put a really solidified and serious offer forward, they want to make sure that it's not just a in vogue type product, but that it's really backed by a well run business and organization. So what we often say is, you know, in this segment of the market at least, buyers are not buying products, they're buying businesses. So ensuring that you have an experienced management team, structured processes, defined strategies, defined growth strategies, and also making sure that your accounting practices and finance practices are really solid.

Speaker B: This is all incredibly helpful and another dynamic, because M and A can kind of unfold or start to unfold in interesting ways. And it's very easy for founders of all sizes to get inbound from corporate development, from private equity, from growth equity. I guess more with an M and a emphasis. Like, some of these conversations can kind of start one off, seemingly a little innocent. Like, what general advice do you have to founders or CEOs who are interfacing with corporate development or potential acquirers outside of a formalized process?

Speaker A: Yeah, that's a great question. And I'll start by saying, if you're getting a lot of inbounds, that's great. It's really good. It's a good signal people are interested in your business, you're doing something right. And if you're thinking about running a process, I would say that it's really important to make sure that you're keeping track of all those inbounds. Just so when you do go to market, you and your advisor can ultimately evaluate if this person actually makes sense to include in your process. And if they do, great because they already know of the business, they're aware of it, things can speed up a little bit faster. If you're not considering an exit, that's when things are a little shifty, as you mentioned. So just making sure that you're balancing the conversations with parties that maybe are a better fit for you because you will be spreading yourself very thin if you respond to every inbound that comes in and ensuring that, for example, for a strategic company that comes to you with a corp dev team, that it really aligns with your industry, your growth plans and your vision for your business. And if it's a private equity firm, um, you know, seeing if they have relevant experience or that they have a focus in your company or your company's stage of growth. I would, you know, also be wary of, like, sharing too much information without an NDA in place, for example, and just, you know, maybe fostering conversations around along the way, but not providing everything upfront until, you know, either you're ready to run a process or, um, you have a MA advisor to kind of feel those requests and not get too deep too fast.

Speaker B: And kind of along that line, like, let's say a conversation feels like it's going deeply quickly, but the founder realizes, like, hey, I would like to add some competitive tension, start some type of process before Just negotiating with one party. Like, do you have any tactical advice there?

Speaker A: That's happened quite frequently, actually. A lot of our processes get kicked off by an unsolicited offer from a buyer investor, and oftentimes those parties will respect that. Uh, it's a fiduciary duty to your business, your shareholders, to your board, to make sure that you are getting the best valuation, best offer for the business. So, you know, they're not going to be the happiest because now they have to go through a process, but they typically understand are very respectful of that process. And it's also making sure that the messaging is right, that, uh, you know, you're not going out and just shopping this bid. You respect the relationship. But like I said, you need to do this out of, uh, fiduciary duty to your, to your company itself.

Speaker B: Awesome. This has been like, great coverage of, like, process on the basics of M and A. Another resource of yours and your firms, uh, was the 20 factor valuation scorecard. And we'll have it in the show notes. And it goes through what you would expect, 20 factors and how they impact your valuation. Could you maybe give an overview for folks of what that resource looks like?

Speaker A: Yeah. So it's literally a card that has all the factors that segment has really evaluated and built over the course of two decades. And it's our way of evaluating software companies and assessing their readiness for exit. It's really the tool that we use pre engagement to help software company founders and their teams understand their business's strengths and perceived weaknesses at a high level. And if for some reason we say, hey, this portion of your business can improve or this is an area that, you know, may cause issues in market, it gives them the opportunity to go back and say, okay, well let me try to work on these things and then maybe I'll be more ready to go to market. And we assess, uh, both quantitative factors like ARR and ebitda, uh, as well as qualitative factors like management teams and delivery models. Because when we look at a business, like I mentioned, it's not just part of product. It's a really holistic view of the organization. And we're able to, by looking at that, provide really thorough feedback to founders and management teams.

Speaker B: Interesting. And you know, in, in all of these things, there's always threshold points where, like, the pool of buyers changes. And I'll just theorize above 5 million of ARR, like, what are some, like, threshold points you're observing in the market that are kind of like key points or even For a goal for a founder or CEO to shoot to that, like hey, once I get to 5 or 10 now I know I'll be really able to like unlock a universe of potential buyers.

Speaker A: Yeah, it's a great question. And because we look at businesses as a whole, as a whole, there are certain thresholds that we're taking into account. And when you know, we're evaluating the markets, it shifts right over time. But I would say in today's market, buyers and investors are really deeming a high quality asset as one that's growing profitability. And you know, the growth at all cost model is not really interesting to the majority of the market right now. So talking thresholds, talking broad strokes, we really like to see businesses with a Strong Rule of 40. And a rule of 40 is the sum of ARR growth and EBITDA margin and one that's not dramatically outweighing the other. So for example, a company with negative, negative 10% EBITDA, 50% ARR growth, that's, that's not super interesting right now. It may be for some, but I would say if you're trying to find kind of the median or the average of what's going to be attractive in market, you kind of want to see something that's more equal. And another threshold that we always think about is the one that you called out is ARR and kind of scale. And you know, companies with less than ARR, $5 million in ARR can definitely get deals done and do get deals done. But I would say at that point the buyer community is a little bit limited. And that's just because buyers and investors see a lot of risk when you're below that threshold and they don't see enough market penetration to be attracted to them. That said, when you're looking at private equities who have portfolio companies, they're extremely acquisitive and that add on opportunity is kind of where they would go down market below that 5 million dollar threshold makes perfect sense.

Speaker B: And, and one of the factors on the scorecard that was a little lower than I would have guessed was total addressable market or tam. Uh, can you expound a bit on that?

Speaker A: Absolutely. So I, I'm always going to try to talk about, you know, strategics and private equities because sometimes it's just a different world. So when we think about strategic parties, they typically care less about this metric because they're typically acquiring businesses that they're trying to extend product functionality, gaining market share. They typically know the market already, cross selling opportunities, market extension Et cetera. When we think about the private equity community who many have the goal of exiting their investments in three to seven years, TAM is going to be really important and it needs to be large enough for the next buyer to be able to continue to grow the business and gain market share. So when you think of TAMS and you're seeing TAMS are less than 100, 200 million, it's pretty tough for those PE parties to get comfortable with. But there's always ways to expand tam. And the way you expand TAM is, you know, extending markets, building additional products, serving more types of customers and so on that thread, uh, the reason why tam's a little lower is because it's an easier problem to solve for really with some investments in product, investments in go to market function and it's easier to position around versus something that's you know, like a super heavy cash burn which is pretty binary for a lot of folks.

Speaker B: That's really good commentary and another resource we'll have in the show notes and it's one of the things that you know, got SEG on my uh, radar long ago was your M and A reports and your other content that get on their newsletter. You're going to find a lot of good PDFs and one of which was this Buyer Perspectives report. And for the year I was reading before this show there was 85% indicating more competition on the buyer side for high quality assets. And you're seeing 118 growth in indications of interest for, for assets you are selling. Like any updates on some of the, those competitive trends and you know, IOI trends and just level of, of interest in processes right now?

Speaker A: Yeah, we're still seeing a lot of demand for SDG's clients and it's great but it tends to be because we are working with those companies that uh, the market deems as high quality assets. And when I say high quality I mean growing profitably and providing mission critical offerings. And so in 2024 and kind of through the end of the year we've seen so much pent up demand for assets that look like this that you know, competition is still high, people are still eager to do deals, we're still getting great multiples on our company. So I'd say that trend has definitely continued into 2024.

Speaker B: Yeah, it's a theory and I've asked some investors on our podcast and of course they didn't respond terribly well to it is, you know, if you look at software and how it narrows down like it's really hard to go up, uh, each threshold from 10 to 20, let alone 50, while still having profitable and a growth story that will continue. But these are beautiful businesses and there's all of these pools of capital, private capital, interested in these things. And so there's almost like a supply, demand imbalance. Do you see any agreement there? And in my pontification, yeah, it's, it's

Speaker A: interesting because I'm, I'm just going to speak from our experience, right, because we've worked with companies in all of those thresholds and there, there's going to be a market for companies at all of those stages. The private equity community is large and it makes up a large percentage of deals every year. And every firm kind of has their own criteria and what assets they're interested in pursuing. A lot are going to be focused on the lower market. So 5 to $10 million in AR. Others are not going to look at anything below $50 million in AR. So while there may be a supply and demand imbalance, I really think no matter what, there will be a market for companies that are in any size range. But like I mentioned earlier, where it gets a little bit trickier is when you're below that $5 million threshold. But beyond that I think there's, there's always going to be demand.

Speaker B: That makes sense. And another thing that, that jumped out from Your full year 2023 M&A report was the gap between the average deal size and the median widened. And I'll just quote, there was a higher than usual volume of low multiple deals as a result from negative transaction catalysts like evaporating cash Runway, challenging debt dynamics, competitive concerns, or investors opting to exit their lower performing assets to focus on high performers. Those are all very interesting commentary. Anything you want to elaborate on there?

Speaker A: Yeah, uh, it was a very interesting year. 2023 was very telling, I would say. And everything you just rattled off is the reason why the market was perceived as so poor last year. Whereas when you're looking at, you know, the deals that were getting higher multiples and you know, were very strong, those are those high quality assets. But if you're looking at the broader market and you're seeing there's a lot of low multiple deals happening, actually the volume is really high. That's the whole doom and gloom. Everybody's thinking, wow, it's just an awful market. But then when you look at these high quality assets, they're still continuing to receive premiums and for companies that don't fit that profile, they are going to be transacting at lower multiples it is for a number of reasons. There was a lot of market uncertainty last year. The cost of capital was extremely high. And like you mentioned, investors were reaching the end of their investment cycles. They want to focus on the companies that are performing really well and maybe exit those that weren't. But when we look forward to 2024, I mean, even this morning, the Fed indicated three rate cuts this year, which is great because that will lower the cost of capital, it's going to encourage higher valuations. It's looking like a really positive year. And you know, everybody keeps talking about election cycle, election year, which always is going to present some risk, but the Fed is ultimately going to dictate monetary policy. And so we, we think it's going to be a really positive outcome for deal volume and getting people excited and competitive in terms of valuation for deals.

Speaker B: It's interesting, I was having a conversation with a private, uh, equity partner in software and one of his kind of complaints was he was like, people thus far have been hesitant to bring their good assets to market, Right. And so there's fewer of those out there and he's waiting for more of them to. Have you seen that trend? Do you expect, uh, things to open up a bit more?

Speaker A: Yes. And yes. In the same report, the, the buyer perspective report that you mentioned earlier, we surveyed not just the buyers and investors, we also surveyed CEOs. And because there was this really poor outlook on the market, uh, for all the reasons that we mentioned, a lot of the CEOs that we've spoken, spoke to were just scared. They said, why would I go to market now when I can wait? We're at, when we're out of this poor market, quote unquote, and get a higher valuation for my company. But there was really a mismatch of understanding because they're getting all of this doom and gloom, all of these, you know, headline news that's saying the market's bad, but if you're a high quality asset, you're still receiving premiums. So it's really this kind of market education to let people know that if you are a high quality asset, you're going to perform really well. And typically that's the case in any market. And I do feel that this year, because the market is stabilizing a bit, you know, rates are coming down, that there are going to be very good quality assets coming to market this year.

Speaker B: Interesting. And, um, one thing, I probably should have done this earlier, but like, maybe go even more detailed on like, type of clients you work with kind of the ideal client profile for seg.

Speaker A: So when we think about, you know, scale, the clients that we work with are anywhere from you know, $5 million in ARR all the way up to $30 million in ARR. So you know, lower middle market, occasionally we'll go past that and below that, just depending on the situation. Below that, you know, it's a really interesting company. We know there's a market out there because there's a lot of private equity with port codes, whatever it may be and above. When we know, assess the situation and decide if that's a good fit for us. And then when we do look at a company, we use the 20 factor scorecard to ultimately see if it's a good fit for us. We're typically dealing with companies that uh, the market would deem as a high quality asset. So growing profitable and providing a mission critical solution to the market. And the reason why I say all of that is because we really pride ourselves in our ability to get deals done. We're absolutely not a volume shop. We're very selective in the companies that we take on as clients and that uh, ultimately results in an extremely high first pass success rate. So I think the number was like 88, 89% of the time we're getting deals done the first time around, which is much higher than the market average. And it's because of the way we run our processes, but also because of the types of clients that we work with and choose to work with.

Speaker B: And it seems like you have some degree of specialization or track records in verticals. I've seen a lot of real estate tech. Like any elaboration there on where you guys spend some of your time?

Speaker A: Yeah. So a lot I laugh because there's a small misconception in the market that we are only real estate tech M and A advisor, but we do go across pretty much every type of SaaS software vertical. We've done a lot of work in real estate. We've probably done more work than anybody else, but we've done a number of deals in education, energy, healthcare, really across the board. If you're uh, you know, vertically focused, then it's definitely a interesting opportunity for SEG. 80% of our deals are with companies that have a vertical focus.

Speaker B: And I apologize, I didn't want to further the, the real estate aspect. It's hard to remember all the verticals and yeah, I don't want to make you guys seem like you do more in one area than you might. So yeah. And you guys have a lot of resources by the way that again, we'll put in the show notes that you have some of these vertical market maps and kind of vertical. Maybe you could just speak to what those things are.

Speaker A: We have a very extensive library of content. So like you mentioned Matt, a lot of research reports that are very detailed and extremely helpful. Whether you're, you know, a seller, somebody that's just running their software, SaaS, company, a buyer, investor. It's really helpful to anybody. We go into market dynamics, trends in the market, all of that good stuff. We also have a lot of content for know, CEOs, management teams, founders that are really looking to either just run their business more efficiently or preparing for an exit. That's all of our blogs. And like you mentioned, we have new assets on the website that are market maps. So we have, you know, education market maps, we have real estate market maps just to show, huh, kind of the lay of the land, how the market segmented, a couple players in the market. So the marketing content and kind of the research content is something that we really pride ourselves on because it's our ability to, you know, help the broader market, provide information to the broader market and our assessment of the broader market. Because I could throw a bunch of data at you, but without the experience and expertise to really analyze it and tell you what that means, it's pretty useless. So that's all on our website. Everything can be downloaded from our website and our, you know, marketing and blog page.

Speaker B: Awesome. And I'll give a plug to the M and a report that I think I've been reading for, I don't know, 12, 13 years now. And I always, what I appreciate in that one too is uh, how you cover the deal share of private equity and private equity backed. Right. Like that's a good nuance. And I think people miss one. How many deals are out there? I think 20, 23 there was 1200 SaaS deals.

Speaker A: Right.

Speaker B: Which is way more. It's not all of these Cisco buys, splunk type of deals, but there's a consistent churn and volume of middle market deals and then the private equity detailing which obviously drives so much of that volume.

Speaker A: Yeah. And if you've been reading our research for 10 years, you've seen how that has changed dramatically. Um, PE. PE backed strategics making up 50% of deals almost. Whereas you know, five, 10 years ago that it wasn't even a thing. So it's really interesting to see those

Speaker B: trends and I guess maybe an interesting thing to that point in your valuation scorecard or just in your general experience like any premium on something that could serve as a platform. Right? Like where you, you buy this foundational asset and the sponsor kind of has a viewpoint. Hey, we could go do four or six add ons using this as our core platform base.

Speaker A: Yeah, it's a great question because that's often the case where a platform deal will derive a higher valuation. But where we see really premium valuations on companies that are add ons is when you're really filling a gap for that portfolio company. Whereas if you're just thinking, you know, a typical PE thesis where it's just buy and add on and add on, where you're thinking more of this is a platform, but this can really open up our market, or this is filling a gap in our solution that we really need and our customers are asking for, you can really get a pretty substantial premium on valuation.

Speaker B: Awesome. Well, I'm glad we covered a lot of ground here, and I think we still got some good basics in. Is there anything you want to promote? Just give overview of SEG in terms of how they can best work with you. Something of that nature?

Speaker A: Yeah, absolutely. So I, uh, just want to promote kind of the content that we have as we talked about. I think it's extremely helpful for anybody. That's all on our website. We do have a 20 factors page where, you know, if you are looking to, you know, get some of that information, maybe work with us and have us do that analysis for you, be happy to take a look and, you know, perform that kind of analysis for you. So it's really exciting. We're excited for the year ahead and, uh, this was a fun podcast. So thank you, Matt.

Speaker B: Awesome. Well, look, everyone go in particular on this episode. Um, all of our shows read the show notes and find the resources, but in particular, check them out on this one. All right, thanks so much, Diamond.

Speaker A: Yeah, thank you, Matt.