When Debt is Better than Equity for SaaS Startups

Much has been written lately about the future opportunities for debt financing of SaaS startups. Of course, there are already a number of excellent debt options under the moniker of revenue loans. Personally, I’ve seen the upside and downside of debt for SaaS companies.

Let’s take a look at when debt is better than equity for SaaS startups.

When Debt is Beneficial

Limiting Dilution

Every entrepreneur hates the heavy dilution that comes with a round of financing. Revenue loans and other forms of debt often have no equity component, and when one is present, it’s minuscule (typically 1% or less). At Pardot, we never got on the venture funding treadmill and used $3M of bank debt to fuel growth while limiting dilution (most venture-backed startups only use debt as a safety net).

More Optionality for a Future Exit

Each up-round of equity funding also raises the valuation, and corresponding minimum target for an exit as investors often want to make a return of at least 3-5x the investment valuation. Debt provides a funding mechanism for entrepreneurs wanting to grow faster without changing any expectations as to potential exit outcomes. Generally, the less equity raised, the more optionality for a potential exit.

Ability to Reach a Value Milestone

In SaaS, there are certain financial milestones, like $10 million in annual recurring revenue, that open up a variety of new investors and exit opportunities (e.g. many private equity funds). Debt has the potential to extend the runway enabling the startup to reach a key value milestone.

Now, debt can be worse than equity in many ways as well. Here are a few of the more common.

When Debt is Problematic

Lack of Repeatable Customer Acquisition Process

One of the main tenants of SaaS is the predictable nature of recurring revenue. Only, a SaaS startup can have a number of customers without actually having a repeatable customer acquisition process. When debt is used in an attempt to accelerate growth, and customer acquisition isn’t repeatable, things are actually made much worse due to ballooning costs without the corresponding growth in recurring revenue. This is premature scaling, and funding it via debt or equity has killed many startups.

Inability to Fund Potential Growth

SaaS growth is terribly expensive (see Startup Killer) as costs to acquire customers are spent upfront while the new customers often pay monthly over an extended period of time. When signing customers faster, cash consumed increases. SaaS debt often maxes out at 3-5x the monthly recurring revenue, making it difficult to fund potential growth as cash is consumed faster than recurring revenue grows.

Covenants Constraining Cash Usage

Debt comes with strings attached. Capital providers often require covenants like one month’s cash on hand, gross renewal rates better than 75%, and sales to board-approved plan of at least 80%. When covenants are broken, a variety of penalties apply, which can force more limited use of future cash and tighter restrictions. Breaking a covenant or missing a debt payment can lead to serious challenges.

Conclusion

Debt isn’t the ultimate funding source but does work well for scaling SaaS startups looking to limit dilution, maintain optionality for exits, and striving to reach a value milestone. Currently, debt funding comes with a number of challenges, the biggest one being there isn’t that much debt available as a function of recurring revenue to move the needle. All said, SaaS startups should add a potential debt strategy to their plans.

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