Debt for SaaS companies done right is a gift. Done wrong, it can weigh you down like an anchor. Few folks have more data than Nathan Latka and he offers up some insights on how to properly leverage up in SaaS. — ed.
Carlota Perez argues in her book Technological Revolutions and Financial Capital that in the early days of a “golden age”, financial capital is necessary to fuel new technology innovation.
Once that technology is better understood, production capital moves in to drive mainstream adoption of the technology.
Geoffrey Moore calls this group the Late Majority and the Laggards in his book Crossing the Chasm, a secret bible for many SaaS CEO’s.
This article looks at the history of SaaS as it relates to financial capital and production capital.
I argue that standard saas metrics make it possible for founders to scale using debt capital (production capital thats cheaper) instead of solely relying on venture capital (financial capital thats more expensive).
2004 Salesforce IPO Brought Financial Capital to SaaS Founders
With the Salesforce IPO in 2004, we saw the first sign that institutional investors were comfortable with a standard set of SaaS metrics: Churn, sales efficiency, ARPU, LTV, customer acquisition cost, and so on.
It’s hard to imagine a world where analysis didn’t understand recurring, subscription based revenue for technology products.
This CNET article captures the uncertainty well:
“Salesforce’s IPO is also seen as a test of a new business model that could shake up the software industry. The company is the poster child for subscription-based software, a model that’s gaining popularity among corporate buyers. Analysts predict that the success of Salesforce and others like it could pose a challenge to old-guard software companies, including SAP, Siebel Systems, PeopleSoft and Oracle.”
This set of metrics that Salesforce began to standardize enabled other providers of Financial Capital to more quickly analyze new SaaS companies and invest.
As a result, you saw financial capital in the form of Venture Capital flow into software companies at record rates over the last 20 years (approaching $1 trillion dollars in total according to Statista)
2004-2010 marked the early days of SaaS where the model was still risky, and cloud providers were competing hard with their on-prem predecessors.
Because the SaaS model wasn’t entirely proven, venture capitalists took more risk, and expected a higher return.
Best in class VC firms over this period delivered IRR’s of greater than 40% to their Limited Partners.
Cheaper capital was simply not available because SaaS was still in the early adopters phase of Geoffrey Moore’s chasm model.
Things started changing in 2011.
As SaaS Metrics Become Standardized, Banks Want In On The Action
In 2011, Hootsuite raised $3m in venture debt before raising another $50m in debt from CIBC in 2018.
Digital Ocean took $40m in debt from Fortress in 2014 after doing a Series A with Andreesen Horowitz. In 2016, Digital Ocean opened a $130m credit facility with Keybanc.
This venture debt is a form of production capital. Debt providers take less risk, and expect less reward due to the predictive nature of a standard set of SaaS metrics.
Fast forward to 2020, SaaS metrics are so well established that there are ETF’s that trade almost exclusively in SaaS stocks.
The SKYY First Trust Cloud Computing ETF has grown to $3.3 billion in assets under management with large holdings in well known SaaS brands like VMWare, MongoDB, and Citrix.
This standardization of SaaS as a business model is why we’re seeing more debt deals in business headlines today.
Don’t VC’s Want This Dealflow? Why Let Banks In?
In 2004 the Salesforce CRM was the shiny object every dollar of financial capital chased.
If the move to the cloud was the next big thing, and companies didn’t have to build or buy servers but could instead subscribe and pay over and over, VC’s wanted in.
After a decade or two of financial capital saturating these new SaaS ideas, the companies started competing with each other with bigger warchests full of VC dollars.
Billions of dollars went into chasing the next big CRM after Salesforce. Google advertising spiked for the keyword “Best CRM”. Everything got more expensive.
This competition makes it much harder to build the next billion dollar SaaS company VC’s need to hit their 40% IRR targets.
It’s no longer viable for financial capital to invest in the next CRM or sales automation tool.
As a result, founders with healthy SaaS businesses are hearing “no” more often. VC’s have to turn away better and better companies.
So where does a $3m revenue SaaS founder building another sales automation tool turn if they want $500k to invest in a new engineer, account executive, or marketing test?
Venture Debt for Founders With $3m in ARR
Most VC’s have already placed their sales automation bets so they pass.
This sort of company is a perfect fit for production capital that doesn’t need massive returns.
Churn under 10% annually? Check.
110% net revenue retention? Check.
Payback period 12 months or less? Check.
Gross margin 85%? Check.
Quick ratio between 2-4? Check.
Rule of 40? Check.
Sales efficiency ratio? Check.
These metrics de-risk the business allowing founders to build wealth, while building their idea, on the back of cheap production capital in the form of debt.
VC will continue to play a role where founders are taking incredibly large risks with outsized returns.
Cheap Production Capital Will Fuel Most SaaS Founders Over Next Decade
Why haven’t more founders turned to cheaper venture debt options as they look to scale?
I think there are two reasons.
The first comes down to education. Many SaaS founders don’t understand how debt works.
With companies like MeMSQL raising $50m in debt last week, you’re going to see this understanding of debt permeate the overall SaaS market over time.
The second is speed. Right now, it’s painful to work with a bank to get debt. Banks tend to be slow, require lots of paperwork, and top it off by asking you to fax in your signatures.
Since 2016 more forms of production capital in the form of debt have become available to SaaS entrepreneurs at earlier and earlier stages of their company.
Firms like Triple Point, Hercules, CIBC, KeyBanc and others have provided billions to SaaS founders on top of (or in replacement of) capital from “more expensive” VC firms.
Is there a not too distant future where SaaS debt as an asset class tops $100 billion?
Someone needs to build a credit machine first. Underwriting currently takes too long and founders don’t have the time.
Building a Machine for SaaS Credit Scores
Why hasn’t someone built a tool that assigns SaaS Credit Scores to companies where higher scores qualify for cheaper money? Just like consumer credit scores.
The founder connects their bank, stripe, and other assets, gets a score, and in 30 seconds or less can accept or reject a debt offer.
The question now is how to do debt better, faster, and cheaper specifically for SaaS companies.
Slack just issued $750m of its own bonds at a 0.5% interest rate due in 2025. What if a $5m ARR SaaS startup could do the same?
That’s what the future looks like. The debt machine is coming.
It’s something I’m thinking about building. Want to work on it together?
Email me at nathan latka at gmail.com.