any thoughts on a carve-out (almost "free" company)?

June 13, 2020

by a searcher from Claremont McKenna College in San Francisco Bay Area, CA, USA

Now evaluating a carve-out from a $150+ M SaaS company ($20+ M ARR); that is, spin-off a non-core product line and small team (in this case, it's a ten-year-old SaaS product with $2 M ARR with thousands of paying customers) into a new company. Curious what special protections and agreements are important to put into place? Where do these deals typically fail? Of course, the risk can be a lot higher, but the price can be a lot lower, than buying a company outright. Thanks for any thoughts. Best, Andy

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Reply by an investor
from Columbia University in Dallas, TX, USA

A few concerns leap to mind. Private message me for more. About a carve-out, that makes IP, shared services (like Nate mentioned), and lots of other line-drawing crucial. Have they been bundling with other products? If so, sales numbers may be squishy, and QOE analysis could be helpful -- but also will be harder to do. Temptation in SaaS acquisitions is to get too stuck on financial metrics in due diligence but not dive as deep into the product and what's on the horizon -- technically for the product itself as well as in the competitive environment. Historical revenue/EBITDA, customer stickiness, overhead, reputation, etc. may all be great. But from the limited description, my chief worry would be that you end up with a legacy product and a team where there's been high turnover and no seller commitment to continue to provide technical/engineering support, but they have also not invested in keeping the product compatible current with all platforms it's meant to run on or integrate with. Imagine an iPhone app with thousands of subscribers but a developer who stopped investing and it's therefore not able to work on the latest or next version of iOS, or all the people who originally built it or who did any upgrades/patches more than two years ago are long done. And, of course, depending how their product is distributed, you may have to solve for a lot of tricky assignments, waivers, or consents with re-sellers, or other platforms on which it is sold. Again, analogizing to Apple, if they sell through the AppStore, but the licenses/integration are in the parent cos name, you might not have the leverage to renegotiate equal terms with all the counterparties -- make those conditions to close. Depending on the industry, you may also have ballooning overhead from customers who will only keep the product if it integrates with legacy platforms/software (e.g. because they don't want to upgrade their network or systems). Buying an older SaaS product raises a lot of product issues -- including often inability to add new features that are necessary to compete. I'd have to know a lot more, but shooting in the dark based on "free" and ten-year-old, make sure you do a deep engineering/developer dive into the technical side of the product. The technical side can be hard to get access for -- since seller may view a look under the hood as akin to giving up the recipe for the secret sauce, or for other reasons. You should also get serious indemnification for IP ownership/non-infringement -- if you buy but it turns out any essential part of the source code is stolen, you're in trouble. There are ways to DD that, but you should be sensitive to SaaS relevant issues in your SPA.

Reply by a searcher
from University of North Texas in Campbell River, BC, Canada

All the comments above are great. When it comes to a 'spin out', regardless of how it is set up inside the mother-ship, you want assets and people, not a company. In other words, assets are sold to you (NewCo) and people who are coming resign from one and sign up for the other.

I wouldn't, for example, take a sub's corporate books rather they keep it, you buy the assets and put into a clean company with no liabilities coming forward. Sometimes, BigCo buys littleCo and X period of time goes into 'what's core' analysis and decides littleCo has to go. Great, buy the assets so you won't be surprised later down the road with any issues lingering from LittleCo. The 'spin-out' is your NewCo.

I've seen founder 'buy' their company back only to get crushed with warranty claims because the original buyer, well, screwed up. The founder should have left the shell behind, bought the ip, customer list, trademarks, etc. and combined that with a hefty indemnity from BigCo would have been way better.

Rick

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