Software as a Service (SaaS) companies took software out of shrink wrapped boxes and put it in the cloud. They've changed everything from how individuals do taxes to how massive supply chain partners work out multi-million dollar global purchases.
Instead of requiring a one-time purchase, possibly backed by an ongoing customer support agreement, SaaS operates as a subscription service, collecting revenue from customers as long as they use the solution. The promise of professional maintenance and ongoing updates is usually included.
An $85.1 Billion Business
SaaS today is big business. Very big. Gartner projects $85.1 billion in SaaS revenue in 2019, and total public cloud revenue (which includes business process, security, and infrastructure delivered in the cloud) at $206.2 billion. And although high-profile acquisitions of SaaS companies with an average deal size of $1.3 billion dominate the headlines, only a few hundred SaaS firms do $500 million in annual revenue.
The truth is that there are many thousands of much smaller SaaS companies with more modest but also more pressing finance needs. At the market's peak in 2014, nearly 2000 SaaS companies took seed investments. That number has declined as the market has cooled, but may also reflect other factors, like a growing reluctance to give up too much equity too soon, and a growing awareness that there are other ways to finance SaaS growth.
Where are the Banks?
Traditional banks have struggled to play a more active role in SaaS company growth. On the surface, a SaaS firm lacks many of the time-honored hallmarks of creditworthiness: inventory and receivables. With intangible assets and technology that, despite decades of proof points, some banks would still consider experimental, SaaS firms find it difficult to offer the deep book of traditional net 30 or net 60 receivables, or even much collateral at all. This can make a conventional line of credit difficult to obtain in any meaningful size.
To be sure, banks have extended financing to SaaS companies in the past. “This is good, and it helps overcome the fundamentals of their structure," writes Todd Gardner, founder and managing director of SaaS Capital. “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."
Conventional loan products aren't always suited for the fast scale up of SaaS companies, which target double-digit growth as a matter of course and necessary for survival. And as a result, many young SaaS companies have had to rely on expensive venture capital.
Measuring SaaS Worth Through New Lenses
SaaS companies can burn through significant cash early on in search for customers, particularly when targeting the business to business market. The prize—when everything is executed well—is a loyal, sticky customer base that provides long-term revenue streams and can translate into healthy profit margins.
That's why the institutions successfully lending to SaaS companies have adopted a new set of metrics to fairly assess an opportunity. Instead of traditional receivables, SaaS companies are more typically measured by monthly or annual recurring revenue (MRR/ARR). When combined with a careful look at customer renewal rates and the strength of the company's revenue growth, banks can make educated decisions that aren't tied to 20th century loan criteria. The lending decision becomes about the expected lifetime value of customers today, and the ability to acquire similarly loyal new customers tomorrow. This revenue-based lending reflects a changing understanding of SaaS potential.
Intangibles can also matter. “We want key people to have a high degree of ownership and industry expertise," says BJ Lackland, CEO of technology lender Lighter Capital. “We don't require prior entrepreneurial experience, but I find that most entrepreneurs are happier entrepreneurs the second time around."
He also offers a pair of other shorthand methods to determine the viability of a SaaS company. “In the SaaS business, especially B2B, if a company has 10 solid customers and $25,000 in revenue per month, it's almost hard to kill it," Lackland says.
He also recommends looking at the venture capital world's Rule of 40, which asks if a company's growth rate plus profit margin tops 40. Lackland says that although debt financiers typically don't require that much daylight, equity investors will, so it should be on the minds of all concerned when making a debt decision.
Retaining More Equity Control
Emerging SaaS financing, including revenue-based financing, is taking the difficult personal guarantees and hefty ownership costs away from SaaS entrepreneurs. “The market understands they are more creditworthy than thought by normal banking standards, even though don't have any hard assets," Lackland says. “Revenue-based financing is essentially a royalty agreement, and that works well with SaaS businesses."
SaaS Companies Becoming More Discerning
As lenders come around to appreciating SaaS opportunities, SaaS startups will in turn start becoming more discerning about who they work with. In addition to holding on to more equity, they will be able to select lenders with a track record of success, and for growing with borrowers as they grow.
That's important against a backdrop where more SaaS companies can become sustainable without any equity deals at all. Ongoing structural advantages, like massive cloud infrastructure providers, make it easier than ever to start up and grow a successful SaaS operation with virtually no investment in fixed capital. “It's a bootstrapper's paradise today," Lackland says. “You can build a SaaS company with just a loan for $500,000, grow a healthy business, and own the whole thing."
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The Technology Finance group at PNC Business Credit offers senior secured financing for sponsor-backed SaaS companies. To learn more about our track record and reliable capital solutions, fill out this simple Contact Form or visit pnc.com/donedeal.