You likely already know that the traditional VC route isn’t the only way to fund your SaaS business’ growth. In fact, only about 1% of U.S. startups ever get venture funding. But how can you bridge the gaps in SaaS financing when your business needs help to grow?
Venture debt can provide needed financing to grow AND allow you to keep ownership of your company. But is it right for your business? Which debt model should you choose?
If you’ve ever considered raising funds to support your growth but you don’t want to sell equity, this Hum Capital primer on some other common SaaS financing options will get you started. And better yet, these models apply to almost any type of company, SaaS or otherwise. (Our CEO, Blair Silverberg, recently wrote about how to choose between debt and equity in the first place).
What it is: This is a well-known method for raising cash. A company sells its products/services on 60- or 90-day terms. A factoring firm will buy these receivables for a portion of their face value, often providing the cash practically overnight. For many companies, getting 85% of receivables now is worth more than receiving full payment in 60 days. If the customer pays in full by the end of the period, the factor ordinarily pays the company an additional portion of the invoice – often 10%. Therefore, the company gets immediate use of 85% of its invoices and receives 10% later, netting out to a cost of 5% of the invoice value.
- Be sure your terms match! If your customers pay on a 90-day term, don’t arrange a 60-day factoring deal. Otherwise, the factoring company may charge you additional fees.
- It can get expensive fast. Factoring periods of longer than 60 days become expensive because the factor takes on a loan for a longer period and assumes the risk of non-payment.
- The cost of capital can increase. Say the factor agrees to buy your receivables for 95¢ on the dollar, paying 85¢ up front and 10¢ more at 60 days—as long as you pay the full invoice in 60 days. This works well if you’re a SaaS company, where customers pay an annual subscription on a quarterly basis with low churn. But if you don’t pay the invoice in full on time, the factor charges you for every late period.
- No discount for early payment. If you pay a 60-day invoice in 30 days, you don’t get any rebate on the standard fee. Similarly, if the payment comes in just one day over the 60 days, you still face the full penalty.
- Only one factor at a time. A small to medium-sized company can only work with one factor at a time, because the customer pays the factor directly. (Remember, the factor has bought the invoices.)
- You can’t buy back your receivables. You must be sure you really want to sell those receivables, because if a customer needs forbearance but you’ve factored that invoice, your ability to intervene is limited.
What companies might benefit from factoring?
Factoring is quick and helpful for companies with receivables, so pure SaaS companies rarely factor as payment windows are often short. However, factoring can be a good option if you sell services in addition to SaaS because services often have longer receivable periods. If you want that money upfront, consider factoring. Furthermore, unlike some of the alternatives discussed later, you know how much money you’ll receive. In essence, the factor bets that you’ll collect 99% of your revenues and it’ll pay you 85¢ up front for them, rebating an additional 10¢ when the full amount comes in.
Hum’s Take on Factoring: Quick and straightforward approach to financing the services portion of your SaaS business. Just be sure your revenue streams fit.
What it is: This is a twist on the factoring model. Instead of selling your invoices, you borrow against them. Instead of a fee, you pay interest to the financing firm, and if the invoice is paid the day after you receive the cash from the lender, you only pay interest for that one day. As we say at Hum, it’s “gentler” than factoring. It’s also very easy to do, up to a certain percentage of your total receivables. We’re increasingly seeing this approach with SaaS companies—their revenues are predictable, and it’s great to get the money sooner versus later.
- Keep an eye on your customer quality. Make sure your receivables financing only uses invoices from customers who reliably pay on time. If a customer doesn’t pay an invoice that was part of the financed package (the “borrowing base”), it will be excluded from future packages. The lender won’t charge you more, as a factor does; it just removes that customer from your base. If that happens to be a larger customer, your financial flexibility may be substantially reduced. Consider a customer that represents $200,000 of a monthly $500,000 receivables financing package and its payment arrives late. This could be for no fault of its own—or yours! —but the financing firm won’t consider that customer’s invoices in any future borrowings. In addition, you would have to pay a large amount instantly to correct the contraction of your borrowing base.
- Keep your back office in order. The financing firm bases its payments to you on the borrowing base. You’ll need to provide good, timely information on the quality of the base, so be sure you’ve built up strong back office systems and structure.
What companies might benefit from receivables financing?
For a growing company with predictable and sizable future invoicing, receivables financing can be very appealing. Similar to factoring, receivables financing works if you have services you sell in addition to SaaS and those customers pay consistently.
Hum’s Take on Receivables Financing: Flexible and low-cost. Just be sure of your customer payment trends.
Revenue-based financing/selling future contracts
What it is: These very similar models both involve selling future cash flows that haven’t yet occurred. In fact, they can blend into each other. Strictly defined, in revenue-based financing the loan is based on a discounted future recurring-revenue stream from your anticipated accounts receivable. With future contract sales, the payment stream comes from one or several specific contracts.
SaaS companies are increasingly turning to revenue-based financing, because their model is typically a 12-month contract that customers pay monthly. In essence, the company sells the discounted present value of the payment stream. The lender provides a lump sum based on future revenues, discounted to guard against the risk that some customers may break their contracts.
This approach is cheaper than factoring and extends over a longer period. Moreover, the market is growing significantly: globally, market research estimates that revenue-based financing will reach almost $43 billion by 2027 from 2019’s $901 million, a CAGR of 61.8%.
Selling future contracts can work in two different ways. The lender can provide an upfront payment that reflects the discounted value of one or several contracts and you pay it back. Or it buys the contract outright for a discounted price, rather like factoring just covering a longer time horizon.
- Principal and interest start immediately. Although you sell the next 12 months (or more) of revenues, you start paying principal and interest from the first day of the first month. As a result, the so-called discount rate is much lower than the true annual percentage rate (APR). Very few future contract- or revenue-based financing firms will disclose the real APR. It’s up to you to calculate this and know what you’re paying.
- The effective cost of capital increases with better performance. If sales grow, you will repay the loan faster―but the discount will increase. For instance, if your sales double, you will repay a 12-month loan over six months but the lender still receives the full original amount because the discount is based on the original schedule. In a simple example, if you agreed to repay $100 over 12 months but your revenue doubles so you repay the amount over six, the lender still receives $100 and your effective cost of capital has roughly doubled.
- Be sure it’s right for you. If your company sells on a perpetual license, this is not the financing method for you! If you sell on an annual contract and you’re paid quarterly or monthly or if you get individual, lumpy contracts, this approach gives you money upfront, but at a significant cost.
What companies might benefit from revenue-based or future contracts financing?
Revenue-based financing is the most popular method of SaaS financing that we’ve seen on the Hum platform. If your model uses long-term, sticky contracts with payments over shorter periods, this model can provide the upfront cash that’s crucial for growth.
Hum’s Take on Revenue-based and Future Contracts Financing: A great way to bring forward a long-term stream of payments, but it’s not cheap.
Lines of credit
What it is: A line of credit works like a consumer credit card—you can borrow against it and then repay it. This type of financing is often used to cover gaps in revenues or to finance a project with an uncertain cost. With a line of credit, you establish a certain amount that you can draw from a lender based on accounts receivable, inventory, or recurring revenue. This model’s major benefit is its flexibility—you can draw down and repay each draw on a specific schedule.
- Fees. Often, you need to pay fees simply for holding the facility, regardless of whether you draw it down. The comfort of having easy access to this capital may vastly outweigh the fee, just as people carry American Express cards regardless of their steep annual fees.
- Lender relationship. Frequently, you must bank with that lender or the lender’s partner bank. If you must switch banks or maintain a minimum at an additional bank, you may want to think about the benefits of the credit line and whether you could get more flexible financing elsewhere.
What companies might benefit from line of credit financing?
Line of credit financing is a long-standing bank option that provides flexibility for large projects with uncertain timing.
Hum’s Take on Line of Credit Financing: Flexible. Can get pricey, but great when you need it.
Growth capital term loans
What it is: Growth capital term loans are similar to lines of credit but are typically used to augment VC financing during or after a round. This financing is provided by specialized organizations such as Lighthouse, Silicon Valley Bank, or Comerica. It typically helps you reach a product development milestone so you can raise your next round at a higher valuation. Part of the bank’s premise in making the loan is that your VC backers are committed to the company for the long haul.
The size of the loan is based on the amount of capital raised in the venture round, so these loans tend to be large. In our experience, they can reach up to 4X EBITDA or 1.5X Annual Recurring Revenue (ARR). Industry data shows that venture-backed companies used almost 3,000 debt vehicles that amounted to roughly $25 billion in both 2019 and 2020.
These loans can be either “upfront” or “delayed draw.” An upfront loan is drawn as soon as the paperwork is complete. A delayed draw loan, as you may guess, means you can delay the date you receive the money, thus reducing the cash drag on the balance sheet. Delaying the draw also allows you to sequence funding with your expenses—for instance, if you need to acquire additional specialized equipment later as demand grows.
- You have to pay it back. Debt must be repaid, regardless of what happens to your company. Banks react very differently to disappointing results than do VC firms. If you take debt, be sure you and any equity investors share an understanding about repaying the lender.
- Repayment usually starts immediately. Unless you have arranged a grace period, interest payments may start at once or when you draw the debt down. Even with a delayed draw, the terms may require you to draw down the loan (and start the interest payments) within a certain amount of time.
- Some venture capitalists don’t like to back a company with debt on its balance sheet. Taking debt, especially for a startup, can dissuade venture investors in later rounds because they’d rather see revenue used for growth than interest payments.
- Default looks ugly. If things are going well, there are no problems. But a typical term sheet includes painful triggers if you break covenants, including accelerated payment terms and cash sweeps.
What companies might benefit from growth capital term loans?
Venture debt can provide a crucial boost if you might need just a bit more runway to reach that milestone before your next round. The difference in valuation before and after a major business value accretion point can make it well worth paying some interest. You can also use venture debt to help you capture a market faster than your internal cash flows allow, especially if you acquire customers profitably. Whether you choose an upfront or delayed draw will depend on the lender’s preference and your needs.
Hum’s Take on Growth Capital Term Loans Financing: A substantial amount of capital that can really help your next-round valuation or increase market share. But be sure you raise enough money to cover the debt.
What it is: Acquisition finance, as its name implies, funds your company’s purchase of another operation. The major reasons for acquiring a company include expansion into an adjacent sector, increasing vertical integration in your own sector, accessing technology or engineering talent (acqui-hire), and geographic expansion. Because of Hum’s unique role in matching companies to pre-qualified investors who could facilitate acquisitions, we’ll address this complex topic in a future blog post.
Summary: What’s the right financing for my business?
Here at Hum Capital, the most typical SaaS financing package we’ve seen is revenue-backed finance. Because it’s so much cheaper and easier to start a company now—particularly a SaaS company—you can reach several millions in revenue without raising institutional money. Revenue-backed financing can help you cross the bridge to maturity and seize some growth opportunities.
In closing, don’t forget that all these debt funding options should be used to help you grow. You don’t want to take debt if the company is in trouble. Leverage on a company acts like a sail on a boat—it accelerates an opportunity in either direction. In a big storm, a lot of sail just makes things worse. But in good conditions, putting up the sail can speed you towards your goal.