The Top 10 Tips for Vertical Market Software Investing

1. Don’t over pay. The single most important factor in driving returns in VMSCo investing is seemingly obvious; it’s purchase price. However, it’s amazing how few investors have the discipline to wait for and execute a transaction at a purchase price that gives them a chance at favourable returns. Since VMSCo’s rarely grow rapidly due to the dynamics of their respective vertical market, it’s even more important to minimize the cash outlay (and risk) up front. Good VMSCo’s are steady, consistent growers with returns heavily tied to the initial purchase price.

Most companies with less than $15M in revenue typically have fewer potential acquirers and hence patient investors can command favourable purchase prices. Start with a low price in negotiations and aim for no more than 1x net revenue.

2. Do detailed customer diligence.

What you’re really buying when you purchase a good VMSCo is a book of customers. Sticky, recurring revenue streams come from maintenance or SaaS contracts. Yes, you’ll get other assets and potentially many people in the deal but the primary financial value is in the customers you acquire. Essentially you’re paying to avoid the risk of acquiring new customers and trying to minimize your risk of losing them. This means that customer diligence is the one of the most important, if not the most important, aspect of diligence. Talk to customers, understand customer concentration, look at how and why they use the product, review historical attrition and price increase data. Losing customers will have an enormous negative impact on returns.

3. Focus on what you can control.

Focus your integration plan on what you can control and try not to do too many things at once. For example, despite what the product owner will tell you, it is usually very hard to say whether or not additional investment in a product will drive organic growth. It can also be difficult to determine how additional marketing dollars will drive sales. However, cause and effect in some aspects of the business is relatively clear. If you reduce headcount, your operating expenses will decline. If you make calculated maintenance price increases in a sticky VMSCo, your annual recurring revenue will increase. It takes a while to truly understand products, staff and organizational core competencies so first focus on the stuff you can control and to which you have better line of sight.

4. Increase maintenance (SaaS) prices.

It’s worth repeating. Increase maintenance (or SaaS) prices. Following on tip number three above, if it’s a good VMSCo you can always get at least a 20% maintenance (or SaaS) price increase and probably more, particularly if you purchased the business from the original founder/owner. Most founders/owners struggle to aggressively price their product because they have long-standing personal relationships with their customers. ‘Normalize’ prices across the customer base, starting with the customers you can afford to lose. Give away low penetration modules or other services if necessary to keep customers.

5. Tax, tax, tax.

Tax diligence is tedious and sometimes complicated (particularly in new geographies) but it’s well worth it. Tax efficient acquisitions can often account for double digit returns on VMSCo investments and missing something can leave you open to enormous risk. Unfortunately many entrepreneurs don’t properly pay sales tax and so that alone creates a huge potential liability. On the flip side, structuring the acquisition to be tax efficient can have huge benefits. For example, amortizing IP into a country with a lower corporate tax rate can boost returns. You must have a tax strategy as part of the valuation and integration plan.

6. If the target has absolutely no competition, there is a reason for it.

There are man very bad VMSCo’s out there, some in markets that are just a little too niche. If the target VMSCo has absolutely no competition, there is always a reason for it and you must try to understand it. Either the vertical market is too small (i.e. total addressable market of less than $5M annually), the VMSCo is actually not vertical and the use cases are addressed by some large horizontal player (an HMSCo) or the software does not address a mission critical need...it is a ‘nice to have’. For example, it’s going to be very difficult to raise annual recurring revenue on a ‘nice to have’ product. You must figure out why there is no competition.

7. Stay close to home (at first).

Do your first acquisitions (and integrations) in the geography within which you are the most familiar. It’s hard enough learning how to get a good VMSCo deal done and running smoothly, you don’t also need to be worrying about international tax law, HR compliance issues, new cultures, etc. etc. Not to mention how tough it is to conduct proper diligence in a foreign language. Stay close to home until you’re large enough to pay for regional experts to guide you and if you do invest abroad, make sure the business is large enough (and the returns high enough) to warrant the additional risk.

8. Do annual or quarterly customer visits.

Again, customers are essentially what you are investing in and they must be kept happily paying their annual recurring fees. Visiting customers is almost always worth the time and effort. If you have very low customer concentration try to visit the biggest customers as well as those that are at risk. Talk to the customer support team to determine which customers they haven’t heard from in a while or customers that have big outstanding issues. Customers love visits (they love calls too!) and they need to know the VMSCo management team cares about them. There should be a customer success plan created and maintained for each account and it should include regular visits or calls.

9. Dedicated integration management.

Whether or not you intend to roll up a VMSCo into an existing business, you need someone to own the plan to derive value from the business. This owner should be involved in pre-close diligence and have a clear understanding of the investment thesis. There is too much complexity in even a small acquisition to have a part-time integration manager. Pick someone who has operational experience (as opposed to just investment experience), who is intimately familiar with a number of the tips listed above and who can see the integration plan through until the business reaches its new steady state.

10. Be patient.

This could probably also be the number one tip because patience is crucial to paying a low price and getting a business you can work with. There are many VMSCo’s out there and an investor needs to have the discipline to say no many times before finding the right target. Just remember that the process of contacting and evaluating VMSCo’s is time well spent, provided you are learning and nurturing owners to come to you when they want a liquidity event.

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