By Todd Gardner, Founder and Managing Director, SaaS Capital
When we launched SaaS Capital in 2007, not only did we spend a lot of time helping companies understand why debt might be a good funding mechanism for their growth, we also often found ourselves explaining what SaaS was. Fast forward 10 years, SaaS is here to stay, and there is now a broad and growing consensus that debt can be a very effective funding strategy for SaaS companies. Today, the issues SaaS company executives need to consider are: what is the best debt structure for my business, and who are the pertinent lenders.
To help SaaS companies answer those questions, we developed a framework to navigate the SaaS lending landscape. What follows is a short synopsis of the options available and a deeper review of the core concept behind using debt for strategic growth: maximizing equity value creation. The full report, with several case studies and an Excel model used in the analysis, are available for download here.
Debt Options for SaaS Companies and the Lenders Who Offer Them
SaaS companies generally use debt in one of three ways: as a source of short-term cash flow smoothing, as a core pillar of long-term growth funding alongside institutional equity, or, as a completely standalone source of strategic growth capital.
If the company’s planned use of debt is modest, banks are a good option to explore. Because they operate in a regulated environment, they lend less money with more restrictions than non-bank lenders, but sometimes that’s just fine and meets the stated need. Banks approach lending to a SaaS company differently depending on whether the company is venture-backed or not. Some banks only lend to VC-backed companies, and some reserve special structures only for VC-backed companies. Banks will also consider profitability and hard assets like accounts receivable in their underwriting and structure. Silicon Valley Bank, Square 1 Bank, Comerica, and Bridge Bank are the most active in the SaaS space.
If the plan is to borrow a more meaningful amount of debt alongside institutional equity, then the traditional venture debt community is the most appropriate. There are a dozen or so of these firms, mostly in Silicon Valley, and they generally like to engage around the time of the equity raise. WTI, Hercules, Triple Point, and Golub are a few of the more active ones in SaaS, and they all focus on slightly different deal sizes. SaaS Capital is also active in this market, but we lend to non-venture-backed companies as well.
If the business is looking to use credit as the primary source of funding for the business, or is looking to use debt before an equity raise, there are fewer choices available. On the “earlier side,” below $2 or $3 million or so in ARR, there are revenue- or royalty-based lenders. Lighter Capital is one of the most active in SaaS. At $3 million and above in ARR, SaaS Capital is the most active.
How to Compare the Options: Creating Value through Runway Extension
Within the universe of options described above, there are literally dozens of different structures and approaches, each with a different benefit and cost. How do you know which is the best deal for your company?
The goal of any type of capital raise by a SaaS business is to extend its cash runway for as long as possible prior to the next valuation event, be it an equity raise or exit. Comparing the value created in the business during the financing period to the total cost of the debt is the best way to compare the debt offerings.
The cost of the debt is certainly important, but for most SaaS companies the financing’s impact on the cash runway has a much larger effect on the overall economics. In our Debt Options Guide (download here), we provide specific numeric examples of the costs and benefits of venture debt term loans versus MRR-based credit facilities versus royalty-based term loans, but the overall concept is pretty straightforward. Moderately capital-efficient SaaS companies growing revenue 20% to 40% per year are creating enterprise value roughly 10 to 50 times greater than the cost of the debt required to support that growth. Because of the lopsided value equation above, the additional runway (longer duration) that one debt option can provide over another becomes the key driver of value.
So, the exercise is to model each loan proposal against your company’s forecast over the next few years to see how long each option can fund the business, and then determine the equity value created during the incremental runway extension. The value creation formula is simply: the incremental growth in ARR times the company’s valuation multiple, less the outstanding debt. Refer to our “How to Value a SaaS Company” white paper for more details on the valuation part.
The drivers of the runway extension capacity of a debt offering are:
Size. For a term loan or royalty-based structure, this is the amount of money received at closing. For an MRR line, this is the amount available at closing plus future availability based upon growth in the business.
Duration. Many things impact duration including renewal dates, due dates, amortization periods, draw periods, and interest-only periods.
Covenants. Common covenants are focused on cash burn, profitability, retention, and liquidity.
Some of these structural elements are very straightforward, but a few are worth commenting on.
Annual renewal periods common in bank loans seldom result in a facility being canceled. However, financial covenants are often tightened during the annual renewal, especially in cases where cash on the balance sheet is getting lower. Liquidity covenants shorten the cash runway of a facility more than other types of covenants and should be modeled carefully.
It should also be noted that, to their credit, many term-loan and revenue-based lenders make a series of loans into a business over time as requested and approved. This is good, and it helps overcome the fundamental deficiency of their structure, however, it is obviously not the same as a committed credit facility which grows formulaically with the business over time and can be drawn down without additional approvals as needed.
Lastly, keep in mind that the runway extension period is only the incremental amount of runway beyond what the company could achieve without debt. In the full report, we provide examples which show that debt raised alongside an equity round typically does little to incrementally extend the company’s runway, and hence build enterprise value. The example and the math behind it are worth exploring if you are in the market.
Unlike the traditional use of debt which revolves around a few simple structures, the SaaS debt market is less mature and more diverse, requiring prospective borrowers to do more homework when selecting a lender and structure. Get your spreadsheets out! Staying focused on the purpose of the debt financing – extending the cash runway of the business – allows borrowers to better compare and contrast disparate structures. For SaaS businesses growing revenue faster than 20%, and thereby creating significant enterprise value with each passing month, the runway extending capacity of the debt structure will have an outsized impact on the cost-benefit analysis.
For more detail on the common terms and conditions of the many different types of offerings, and for some examples of cost/benefit analysis, please download our Debt Options Guide here.