When Debt is Right for SaaS Companies

December 10, 2019

The time and cost of starting and bringing a SaaS company to market have dropped from years of building and millions of investment dollars to just months and thousands. However, companies can quickly get off the ground and bootstrap themselves into a growing venture by raising seed money from friends, family, and angels.

While bootstrapping creates healthy financial discipline, it is also very limiting. For example, suppose the company benefits from positive and scalable ROI from Sales & Marketing spend. In that case, 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, outside money is needed again.

Debt or equity?

Debt would be ideal to finance a temporary burn period because it preserves equity ownership and 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 if they don't, the entrepreneur needs to adjust their spending habits to serve the debt.

On the other hand, equity is 'sleepy.' It creates a false impression of free capital. 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,  'alternative lenders' out there 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. So, let's look at some of the characteristics that further qualify or disqualify companies for using 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 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 generating overall growth can become very expensive if the company also has high churn rates and limited customer lifetime value. This approach 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 is 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, 80%, sometimes 90% of revenue. Once the software is built and sold, running it for the customer costs relatively minor in relation to its price point. The combination of recurring revenues and high gross margins give you a reasonably sustainable Gross Profit stream that provides financial safety – you can manage your cost structure deliberately and as needed to serve debt with minimal 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.

Borrowing money requires some primary business and financial hygiene on the borrower's side, 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). After that, 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 a percent of revenues ('revenue-based financing').

That is very different from a non-amortizing, interest-only bank loan extended to larger corporate borrowers, and for a good reason. Non-amortizing loans are much riskier 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). They usually do so by putting a lien on the assets (including a claim on future cash flow to be earned and collected) and requiring a stock pledge. Those requirements are much less demanding than they sound. Appropriately structured, they don't limit the entrepreneurial freedom to build the company but impose discipline on the operator to ensure solvency and liquidity as needed.

Some final thoughts

Debt is an excellent source of capital for sales and marketing investments that drive profitable growth. It may also be suitable to finance accretive acquisitions. However, debt is not ideal for funding software development initiatives with long and uncertain paybacks, to fund longer-term intentional cash burn, or to fund a startup. You need to raise equity for those situations, 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 significant and lasting businesses. It can be sized and timed exactly to your needs and investment opportunities. As a result, 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 lying around.

If you consider borrowing, make sure you 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.

Talk to us about how we can help you. There'll be no hard sell, just a good conversation.