The time and cost of starting and bringing a SaaS company to market has dropped from years of building and millions of investment dollars to just months and thousands. By raising seed money from friends, family, and angels, companies can get off the ground quickly and then bootstrap themselves into a growing venture.
While bootstrapping creates healthy financial discipline, it is also very limiting. If the company benefits from positive and scalable ROI from Sales & Marketing spend, then it should invest more to drive valuable, profitable growth, even if that sends profits and cash flows into negative territory for a while.
But to do that, we need outside money again.
Debt or equity?
To finance a temporary burn period like this, debt would actually be ideal because it preserves equity ownership and it creates strong discipline.
The preservation of equity ownership is an obvious plus for the entrepreneur and early investor – we have all seen and heard from companies that in the pursuit of “glamour and growth” raise expensive VC money and dilute their stakes significantly. Plus the process of raising equity is lengthy and complicated and distracts entrepreneurs from their real job, which is to build and market a product that fulfills customer needs.
Debt also creates discipline – it needs to be paid back, on a schedule. While this creates another constraint, we believe it is a good one. It forces capital to be allocated to initiatives that pay off – and it they don’t, the entrepreneur needs to adjust their spending habits to serve the debt.
Equity on the other hand is ‘sleepy’, it creates a false impression of capital being free. All capital has a cost and all capital invested in the business needs to generate adequate returns – this is economic reality. Debt makes this very visible, whereas equity obscures it.
Who’s lending and how does it work?
Traditional bank loans are unavailable to SaaS companies because they don’t have any physical assets to collateralize the loan and/or they are not profitable (yet). Luckily, there are ‘alternative lenders’ out there that recognize that SaaS companies may have much more debt capacity than traditionally acknowledged. It’s not the physical assets or dollars of EBITDA, but recurring revenue streams, combined with high gross margins that qualify SaaS companies for debt.
Not all SaaS companies at any stage in their lifecycle can or should borrow though. Let’s look at some of the characteristics that further qualify or disqualify companies for the use of debt.
- Recurring Revenue: From the above, it becomes apparent that a qualifying company must have a recurring and ideally growing book of business with acceptable retention rates. If revenue is not recurring and/or if it is shrinking, then the company’s debt capacity is low to begin with or erodes quickly and few lenders are willing to lend against that. The same is true for startups or early-stage businesses with unproven revenue streams.
- Installed Base Health: Understanding both total revenue growth, and total churn is important. Growing revenue is a great start but if the company also has high churn rates, generating overall growth can become very expensive and customer lifetime value is limited. This usually raises a red flag but may be acceptable if churn is caused by certain strategic changes, such as changes in pricing strategy, or concentrated on certain customer cohorts – the point being that the high churn rates reflect the behavior of a legacy customer base that is less relevant for the future revenue generation of the business.
- Gross Margins: SaaS companies typically run with high gross margins, of 80% sometimes 90% of revenue. Once software is built and sold, running it for the customer costs fairly little in relation to its price point. The combination of recurring revenues and high gross margins give you a fairly sustainable Gross Profit stream that provides financial safety – you can manage your cost structure deliberately and as needed to serve debt with very little risk of default.
- One Offs: Other diligence items include cash conversion and working capital considerations (are revenues actually turning into cash? Do we have an overhang of outstanding payables that eat up future cash flows?) and other existing liabilities and indebtedness that consume debt capacity to begin with.
- Finally, borrowing money requires some basic business and financial hygiene on the side of the borrower, such as timely preparation of complete and accurate financials, and adhering to basic covenants and notice requirements.
Typical SaaS lenders require loan amortization to begin right away (very much like paying for your house through a standard mortgage). Monthly payments are made until a multiple of the loan value is paid back (ranging between 1.2x to 1.6x depending on the term and risk of the loan). And those monthly payments are fixed in dollar terms or expressed as percent of revenues (‘revenue-based financing’).
That is very different than a non-amortizing, interest-only bank loan that is extended to larger corporate borrowers, and for good reason. Non-amortizing loans are much more risky and require more collateral in the form of physical assets or, if such is not available, very high interest rates to compensate for the increased credit risk.
When it comes to collaterals and guarantees, most SaaS lenders like to stay away from requiring personal guarantees. If a business fulfills the criteria above and loan amounts are chosen prudently, servicing the debt is more a question of choice rather than ability. Nevertheless, a lender has to secure its interest (otherwise the loan gets very expensive) and they usually do so by putting a lien on the assets (which has to include a claim on future cash flow to be earned and collected) and by requiring a stock pledge. Those requirements are much less onerous than they sound. Structured properly, they really don’t limit the entrepreneurial freedom to build the company but they simply impose discipline on the operator to ensure solvency and liquidity as needed.
Some final thoughts
Debt is a great source of capital for sales and marketing investments that drive profitable growth. It may also be suitable to finance accretive acquisitions. Debt is not ideal for funding software development initiatives that have long and uncertain paybacks, to fund longer-term intentional cash burn, or to fund a startup. For those situations you need to raise equity, iterate slower, or ideally get customers to pay for features they require.
Debt is the financial instrument for success-based investing, an approach that we believe is best suited to build great and lasting businesses. It can be sized and timed exactly to your needs and investment opportunities. You never have to stress out about overfunding your company and the pressure it creates from your VCs, nor will you have too many dollars laying around, of which some will get wasted on less productive initiatives.
If you consider borrowing, make sure you do understand how those loans work and do some financial modeling work in advance to realize how they can fuel your growth without diluting your ownership stake.