3 financing options for SaaS founders (with pros & cons)

July 10, 2020
  • financing
  • revenue-based financing

We founded Pulse to provide an alternative financing option to SaaS founders. Our core belief is that the SaaS model enables a hybrid financing option between debt and equity, that is not sufficiently available today to early-stage SaaS companies, and that would benefit both founders and early-stage angel and seed investors.

 

We’ve talked to lots of SaaS founders and realised that SaaS founders are sometimes having a difficult time thinking through the pros and cons of various financing options, so we’ve started laying them out here.

 

We’re also working on a calculator to help formalise our thinking with numbers. Reach out if you are interested!

 

SaaS founders usually understand quickly that they have a few options when it comes to financing, but don’t always know how to think about the pros and cons. Deciding which is the best option is not a pure financial decision and can be overwhelming.

 

• Are you willing to give up equity for a huge VC payment? What do you get in return?

• Can you handle a recurring monthly debt payment if business slows down? Are you putting your business at risk with a fixed repayment schedule?

• Are you eligible to access revenue-based financing, and what are the benefits of it?

• How much time are you willing to dedicate to fund raising as opposed to growing your business?

 

One of the key things to keep in mind is that there is no one size fits all answer. As a founder, the right financing stack will depend on your goals and where you want to take your business. For example, not every venture is designed to become a unicorn, and there are alternative paths that can reduce your reliance on VC funding.

 

It all depends on where you are and where you’re looking to go.

 

There are not 2, but 3 main financing options for SaaS founders:

 

Two of them are well-known:

• Venture Capital: Financing from investors that doesn’t have to be paid back, usually coming with the expectation of commitment to an “all or nothing”, explosive growth trajectory and an exit at some point over the next 10 years. It’s been the default financing model for early-stage SaaS companies historically. That made a lot of sense back when building software require huge upfront investment before generating revenue, but may not be as much of a fit in a world where it’s becoming relatively easier to bootstrap your way to revenue-generation.

• Business Debt: Financing through a bank paid back at a set amount each month with interest, often coming with strings attached such as equity warrants, collateral or personal guarantees. There’s a lot of scepticism about this financing model historically in the startup world, but we’re seeing things change quickly especially for later-stage companies (Series B and beyond) with more established business models.

 

One is relatively new:

• Revenue-Based Financing: Financing through a private company that shares the risk with you, that will provide cash upfront in return for a share of the future payments of your recurring customers, paid back flexibly in line future MRR, coming with less strings attached. This one is relatively new but very suitable to the recurring revenue model that most SaaS businesses have today.

 

To help you figure out what the best option is for you, we’ve explained the top 3 pros and cons of venture capital, debt, and revenue-based financing.

 

As a SaaS founder, it can be challenging to work out what’s best. Reach out if you need help thinking through it! Even though we start our journey by offering revenue-based financing, our mission is to help all software founders navigate their financing journey seamlessly, and we help you as well get equity or debt financing.

 

Here are the 3 main financing options for SaaS founders and the top 3 pros and cons of each.

Option #1: Venture Capital

Venture Capital Pros:

 

#1: You'll get the most amount of financing out of all the other options

 

The largest pro of venture capital is in the size of the check—VC can fund massive projects way before they get to make profits or even revenue. This isn't the type of money that you'll find through debt or revenue-based financing. That’s why VC makes sense when you’re early, or going for “moonshot” projects with a lot of uncertainty around the outcome.

 

#2: If you pick the right VC, you'll have a valuable partner on your side with access to an extensive network and solid advice

 

Through VC funding, you’re not only getting money. You’re also getting access to a VC network and infrastructure, which can be tremendously helpful with hiring, getting initial introduction with customers, and finding relevant connections to accelerate your growth.

 

You’re also getting access to advice from people who have been there before. Either as previous startup founders, or as experienced investors, you should pick your VC with an eye on the potentially valuable advice they can provide to you as you grow your startup. This can be a huge asset when building a company from scratch.

 

Having said that, VC financing isn’t the only way to find partners like this. There are more and more networks and communities of founders and advisors like Growth Mentor where you can get access to very valuable advisors without giving away as much equity.

 

It’s also important to bear in mind that not all VCs bring the same value on this front. It’s critical that you do your due diligence on the funds that you’re thinking of sharing your equity with, and make sure that they will really bring value to you.

 

#3: You don't have to pay it back out of your company cashflows

 

SaaS founders without cash flow lean into VC funding because they don't have to use their profits to pay back the debt. Instead, earnings are funnelled right back into the company to keep growing.

Venture Capital Cons:

 

#1: You are giving up equity and changing your own incentives

 

The largest hesitation founders have when signing a VC deal is around equity. By signing on for a VC check, you're also giving away a stake in your company and, often at Series A, bringing in investors with incentives not exactly aligned with yours.

 

Often the investors are going to come in with terms that give them a preferred return, meaning that they will get a disproportionate share of the proceeds when you sell if the returns are below a certain threshold. This creates an incentive for you as a founder to aim for explosive growth (for better or worse, depending on how you see it).

 

#2: You’re signing up for a certain type of growth trajectory with higher risks

 

As VC firms make most of their money on the outliers, there is a clear incentive for them to push you toward a strategy that maximizes the chances of doing 10x on their investment. Even if it reduces the chances of doing 2-5x, which for you as a founder may be a perfectly fine and life-changing outcome already.

 

These expectations are quite codified, as seen here in this Quora discussion. The infamous “triple, triple, double, double” is going to be the yardstick for your company in the next 4-5 years.

 

With the SaaS landscape changing, more companies are becoming viable without necessarily being “VC-compatible” as Clement Vouillon points out in this article. So you should try and think where you fit, before signing up for it.

 

#3: You’ll also lose some level of control as to if and when to sell your company

 

If you're building your business based on a passion and you know that you want to stick with it long-term, this may conflict with the VC objective to exit the company at some point. Equally, you may encounter a situation where you’ll have an opportunity to sell your company at a price that works for you, but creates sub-par return for your VC partner. Usually this is not insurmountable, but expect some complex and heavy board discussions !

Option #2: Business Debt

Business Debt Pros:

 

#1: If it goes well, you get to keep 100% ownership of your business

 

Debt is an attractive financial product because it allows you to keep all of the upside when your business goes well. You pay down the principal and the interest, and you retain ownership and control of your company.

 

#2: It’s less expensive than equity financing

 

Equity investors take more risk alongside you, and as a result usually require higher returns. VCs solve for at least 30% rate of return if not more. By comparison, venture debt interest rates can come down as low as 12%. And even though for early-stage companies with less than $3M ARR it will tend to be a bit more expensive than that, it will usually remain less expensive than equity financing.

 

#3: It can be a great way to get your business into breakeven territory, bypassing the need for another financing round

 

If breakeven is within sight but not quite there, which can often the case for companies with $50-200k MRR, you may want to consider debt as an option to extend your runway by 6-12 months and make your way to breakeven territory.

Business Debt Cons:

 

#1: You usually need collateral… and banks tend to think of it in a conservative way

 

If you are not yet profitable, banks will usually be looking at your asset base and ask you to put up some collateral. They’ll look for it first in your company accounts but will tend to take a conservative view as to what qualifies as collateral. If you are a software business, you’re unlikely to have a lot of hard assets on your balance sheet, and that can make the discussion with traditional banks tricky. This means banks will likely turn to you personally and ask you to give some personal guarantees on their loan. This places you as a founder under a significant amount of risk if the business goes south. Or in some markets, simply means banking debt is not available.

 

Venture debt providers who are most familiar with software models will try to take a different perspective and assess your chances of getting another round of VC financing to guarantee their repayment. In that sense, they continue to lock you in the equity financing model – see part one.

 

 #2: There is limited flexibility on the drawdown and repayment mechanics

 

One of the biggest drawbacks of taking on debt as a business is that there is usually limited flexibility on the repayment schedule. Once the amount of debt to be provided to you is agreed, you’ll be expected to draw it down in full, repay it as per the agreed plan – regardless of the conditions of your business. That may work well when you’re operating in a steady environment. But we all know startup life comes with unpredictable ups and downs.

 

You may end up wanting to draw less, or repay earlier than planned, if your business goes through a great time. Alternatively, you may want to delay the repayment if you go through some challenging months. In the classic debt model, this will usually be hard and / or come with additional fees.

 

#3: Debt usually comes with complex terms that hide more strings attached than you’d think

 

Although you’ll get to retain ownership and control once you repay the debt, there are usually terms in the venture debt package that you as a founder should think carefully about. Equity warrants will enable the venture debt provider to come into the capital of your business at the next financing round, diluting you in the process. IP or equity collateral will provide your lender with an opportunity to get control over those assets if the company doesn’t repay. Those terms are part of why venture debt interest rates are often more attractive – they enable the lenders to protect themselves against losses and to share a bit more of the upside when things go well. From the company’s perspective, though, those are terms to carefully think through.

Option #3: Revenue-Based Financing

Revenue-Based Financing Pros:

 

#1: It combines the benefits of equity and debt

 

Like debt, revenue-based financing is non-dilutive. As opposed to debt, it has more flexibility in terms of drawdown and repayment terms, and usually has much less strings attached than a debt package.

 

Like equity, revenue-based financing contains a degree of risk sharing. As the repayment terms are usually defined as a share of revenue, it adjusts to the conditions of your business, scaling up or down in line with your revenue to provide more breathing room when you need it.

 

#2: It can be really fast

 

Although the category was born from funds who have a relatively lengthy due diligence process (which can take up to 3 months to close a deal), new providers are coming in with a tech-first approach, and the ability to reach a decision within a few days. They do it by integrating with your main data platforms (subscription billing, accounting, banking) and applying SaaS-specific risk assessment model to reach a decision very quickly.

 

As a founder, being able to assess the availability of a financing option by simply connecting to your key platforms saves a lot valuable time.

 

#3: It enables you to directly convert your monthly plans into upfront cash and scales with your startup

 

Revenue-based financing for SaaS enables you to convert your monthly plans into an immediate cash inflow. This changes the economics of your SaaS business and enables it to reach breakeven point much faster. As you sign up more customers, your revenue-based financing facility grows, which means you can immediately access future payments and generate cash instead of burning it.

 

Revenue-Based Financing Cons:

 

#1: You'll need to generate some amount of revenue

 

Since revenue-based financing is dependent on you having revenues, you’ll need to be at that stage in order to access this option. Before that stage, bootstrapping, angel and seed financing are probably your best options.

 

There is usually a minimum amount of revenue history that you’ll need to generate before you can access revenue financing (6 months or so). However, connecting your accounts to a revenue-based financing provider early can enable you to access that option as soon as it becomes available to you.

 

#2: You may not access as much financing as you would with equity financing

 

If you are looking for a significant amount of cash to fund your next big bets, revenue-financing alone is unlikely to be sufficient. Equity financing will remain the best option here.

 

However, we are starting to see more hybrid financing stack emerge. Using revenue-based financing as a complement to equity financing can enable you to minimise dilution and get to breakeven faster whilst getting the benefits of the equity injection – but with less dilution.

 

#3: Make sure you’re sharing data with a company you trust

 

The new generation of revenue-based financing players rely on integrations with your key platforms. As a result, it’s important for you to be clear about what the financing provider will be doing with your data. Does it plan to use it with other purposes beyond assessing your eligibility for an advance and monitoring repayments? It’s important to make sure you’re ok with the way your data is going to be used by the financing provider.

 

For example, at Pulse we are committed to not using your data for any other purposes beyond making your financing as seamless and continuous as possible by providing you with a Pulse advance facility in line with your MRR. We treat your data carefully and confidentially all the time.

Takeaways

The best financing option will depend on where your business is now, where you want it to be within a set timeframe, and what ownership you want of your business when you get there.

 

How many options are on the table will also depend on where your business is, both in terms of maturity, growth momentum and geography.

 

The level of confidence you have in your chances of getting to your next milestones will ultimately drive exactly how you should choose the financing option that works best for your SaaS business.

 

• If you are completely positive that you can pay back your loan (with interest), generally business debt is the best option.

 

• If you’re not sure that you’ll be able to pay back debt because you’re in the early stages of your startup, or if you are taking on big bets, VC financing might be the best option for you.

 

• If you are generating revenue, need to access more scalable capital, revenue-based financing is a great option worth checking out

 

Revenue-based financing enables you to keep ownership of your company and avoid giving away any equity. Pulse is a revenue-based financing option specifically for SaaS businesses. We tell you within 24 hours after you’ve submitted your application, how much you are eligible.


To learn more about Pulse, reach out to hello@joinpulse.com, or simply apply for revenue-based financing through Pulse here.


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