In a world where inflation is increasingly an issue, the cost of money is the notable outlier. Interest rates are lower now than they’ve been in 8 years. Savers, starved for returns on bank accounts and government bonds, have decided to take on more risk in search of higher returns.
And so, a veritable avalanche of cash has hit financial markets. Despite a global pandemic, equities have soared. Looking at specific companies underscores how absurd all of this is. Take Ryanair (an amazingly well-run company), for example. Shares of the well-known European airline are near an all-time high, even though its annual traffic numbers fell 81% to March 2021 because of COVID-19.
We know from history that cheap money leads to massive distortions in markets, and today is no different. Just as equities have become disconnected from fundamentals, so too have credit markets. Last year, according to the Wall Street Journal, bonds issued by nonfinancial companies in the U.S. totaled $1.7 trillion—almost $600 billion more than the previous high. Curiously, fixed-income investors have been particularly enamored with the debt of triple-C rated companies. The value of bonds issued by businesses with this lowly credit rating is running 35% higher this year than the prior record, despite many of these borrowers being in a precarious financial state due to the pandemic.
Matching: Not Just for Socks
It’s a cardinal rule in finance: Ensure that the source of capital you are accessing is appropriately matched with your needs and objectives. A person, for instance, would be ill-advised to use their credit card to buy a house or car. In the world of business, founders must be confident that any debt finance they’re taking on to grow revenue won’t inadvertently lead to the company shrinking.
With this in mind, what we see at the moment worries us. In the market for SaaS loans, some lenders are offering 6-12 month term loans at effective annual interest rates of 25-40%. Many of these loans are based on so-called “forward factoring”. In this kind of arrangement, the company is borrowing against estimated future revenues, which can be a risky proposition.
There can be times when short-term credit makes sense, of course. But what concerns us is that some founders seem to be relying on these types of loans for growth finance. It’s a disaster—in the form of a mismatch—waiting to happen.
When you have to pay back a high-interest loan very quickly, the combined interest and principal payments each month are significant. Unless you’ve been able to use the money to achieve rapid revenue growth, your payments can act as a massive drain on your cash flow. With so much money going to your lender, you may be unable to invest in the business, and may end up having to cut staff just to keep current with your obligations.
There is a Better Way
It’s well-known that 90% of new businesses fail within the first 5 years. But what is underappreciated is why so many don’t make it. Many ventures that fail could be viable, yet they run into a cash squeeze that can’t be fixed. Using short term debt for longer term purposes is certainly one of the ways to fall into this category.
Fortunately, there are founder-friendly alternatives for companies who require growth capital. They can obtain revenue-based finance on longer terms, which alleviates potential cash flow issues and allows them time to invest in their business. Moreover, it can be non-dilutive, so you don’t have to give up any ownership of the company you’ve worked so hard to build.
We’re Always Happy to Chat
If you would like to learn more about revenue-based finance to determine if it’s the right fit for your SaaS company, I invite you to Talk to Us. There will be no hard sell, just a great conversation.