When to Use the Checklist
Start by defining your acquisition criteria. Then source leads, record opportunities, and follow up on promising prospects before applying a due diligence checklist.
A focused checklist helps you prioritize important issues and avoid spending time on businesses that do not meet your criteria. Without one, buyers may rely too heavily on intuition and miss important details.
The checklist should be applied iteratively rather than used as a long process for every opportunity. It should come after initial criteria and sourcing, not at the first sign of an interesting business.
Start With the Numbers
Every deal starts and ends with the numbers. Begin by assessing the quality of annual recurring revenue (ARR) or monthly recurring revenue (MRR). Review the trend to determine whether recurring subscriptions are increasing or decreasing.
After signing a letter of intent (LOI), reconcile the reported figures with bank records, financial spreadsheets, and Stripe data. Also compare contracted ARR with run-rate ARR, since large contracts may take time to generate their full value.
Separate one-time revenue from recurring revenue. Smaller businesses may depend heavily on one-time deals tied to the owner’s personal contacts, making those deals less durable.
Review deferred revenue as well. Together, these figures give you a clearer understanding of the financials and the quality of recurring revenue.
Examine Churn and Retention
Understand how long subscribers remain customers, how quickly they leave, and whether retention is consistent. Review both gross revenue retention and net revenue retention. As a general rule, gross revenue retention should be above 80% and net revenue retention should be above 100%.
Investigate cohort curves to see how customers acquired at different times behave. Earlier and newer customers may have different retention patterns because of discounts or differences in the audiences targeted.
Look for revenue cliffs or declines, as well as expansion and contraction trends. These patterns can help you understand the likely quality of future recurring revenue.
Assess Customer Concentration and Contracts
Review how much revenue comes from your largest customers. Reliance on a few customers is especially common in enterprise businesses and creates significant risk if one cancels. Seek as much customer diversification as possible.
Understand contract lengths, renewal terms, and change-of-control clauses, particularly for enterprise customers.
Also assess pricing power. Consider what might happen if prices increased, what percentage of customers might leave, and how existing pricing changes have affected sales and key metrics.
Sample customer calls are another useful way to understand the business. Ask customers about their satisfaction and whether they plan to cancel. The numbers may not reveal a developing problem clearly, while direct customer feedback can.
Review Unit Economics
A common benchmark is that lifetime value divided by customer acquisition cost should be greater than three.
Check whether gross margins are stable and growing. As the business adds customers, margins should improve rather than decline. If profits fall as the company adds customers, the fundamental economics of the SaaS business may be broken.
Explore contribution margins as well.
Evaluate the Technology and Product
Review the code, intellectual property ownership, architecture, scalability, and technical debt. Use someone with a strong technical background or a technical consultant if necessary.
Check third-party dependencies and confirm that all accounts can be transferred. Old frameworks that are no longer updated may make the cost of transferring or updating the product high.
Assess AI dependency and usage. The product should be able to grow as AI models improve rather than being replaced by them. It should also avoid becoming excessively dependent on AI agents and token costs. If token prices rise and represent a large share of revenue, the business may be in trouble.
Check Security and Compliance
Confirm that security practices are stable and transparent, including updates and potential bugs. Review penetration tests and SOC 2 requirements where applicable.
Examine the incident history and whether data privacy obligations under GDPR, CCPA, and similar rules are being followed. Noncompliance can result in fines of up to 4% of revenue.
Check access controls and consider cyber insurance where appropriate. Customer data must be protected and all relevant standards met.
Verify Legal and IP Ownership
Confirm that there is a full chain of title for customer and vendor contracts. The buyer should own the code and other intellectual property, and the seller should be able to transfer ownership.
Review employee and contractor IP assignments to ensure they can all be transferred. If open-source software is used, confirm that usage is compliant.
Check for litigation, claims, and pending legal issues.
Understand Team and Key-Person Risk
Review the organizational chart and determine how dependent the business is on its founder. This is especially important in a growing SaaS company because the founder may handle sales, technology, coding, and planning.
Account for the work the founder performs. It will need to be handled by you or transferred to your team, and the cost of doing so must be included in the deal.
Check support volume and whether the team has well-documented processes. Assess the risk that key people will leave after the acquisition.
Review Pipeline and Sales Quality
Understand customer acquisition cost sustainability by channel, the company’s competitive position, and whether it can continue acquiring customers at the same cost.
Compare the business with competitors in its market. Review recent pricing history and how price changes affected sales and key metrics.
Assess sales process maturity, particularly for enterprise sales. Understand the typical sales cycle, what is currently in the pipeline, and whether prospects will continue smoothly.
A weak enterprise pipeline may be a warning sign. If potential clients have already been sold to and the company is not developing new ones, a new buyer could face a long period without new customers or revenue.
Identify Red Flags and Walk-Away Conditions
Major red flags include:
- Financial figures that do not reconcile.
- Accelerating churn, especially if you cannot identify and correct the cause.
- Extreme customer concentration, such as one customer accounting for 60% of revenue.
- Missing intellectual property assignments.
- Declining gross margins as the business grows.
Set your walk-away conditions in advance. Some issues are absolute risks, while others can be addressed through pricing, contract terms, or the purchase agreement.
For example, a customer accounting for 20% or 30% of revenue may create a risk that can be reflected in the sale structure. Terms could hold back part of the purchase price for a year or two, conditional on that customer remaining.
Many issues, including limited intellectual property problems involving part of the code, may also be manageable. You might locate the owner, negotiate the deal structure, and account for the issue in the agreement.
Some buyers walk away as soon as they find a red flag. Others use it as a negotiating point and obtain a better deal. Do not automatically abandon an opportunity when an issue can be addressed.
The Final Test
Before committing capital, confirm that the recurring revenue is real, durable, and transferable. Also assess whether AI could undermine the business before you begin investing in its growth.