Customer Value SaaS Financing

Several weeks ago General Catalyst, a large investment firm, announced a new type of SaaS financing in their post The Unbundling of “Growth” Equity. Now, there have been a number of alternative financing solutions in the SaaS world for many years now and they all center around lending money as a percentage of annual recurring revenue. This offering from General Catalyst is different: it’s lending against sales and marketing spend with a payback based on the value of the customers signed (disclaimer: I haven’t talked to General Catalyst and I’m interpreting their messaging without any feedback). Let’s dig in.

The most common form of alternative SaaS financing, often called revenue-based financing, lends against committed recurring revenue and a few other factors. Before this type of offering, there were generally only three funding options: customer funded (bootstrapping!), equity (usually venture capital), and specialized bank debt (venture debt that’s going to be much harder to get now with the bank failures). Revenue-based financing is usually less restrictive than venture debt and but often has higher fees and effective interest rate.

Let’s look at an example. Imagine a startup has $4M in annual recurring revenue. Revenue-based financing would provide $1M of debt (roughly 20 – 33% of the annual revenue depending on a number of factors like gross margins, renewal rates, and growth rate) in exchange for a percentage of total revenue for the next three years. The revenue-based lender is making a bet about growth to achieve an outsized return. If the startup doesn’t hit the growth targets, the lender won’t make as much money. Here’s a simplified example where the lender gets a flat 10% of revenue for three years:

Year 1

$5M of revenue

Lender receives $500k

Year 2

$6M of revenue

Lender receives $600k

Year 3

$8M of revenue

Lender receives $800k

So, in this example, the lender receives $1.9M in payments for the $1M loan. While it’s an extremely high effective interest rate, it can be “cheaper” than equity in some instances. Also, if the startup doesn’t achieve their revenue goals, the lender would make less money (or potentially lose money if there was a default). For the startup, that $1M debt might turn into $2M of incremental revenue at the end of the third year, potentially creating an extra $10M in enterprise value. Trading $1.9M in payments for $10M in additional value is a worthy trade.

Now, let’s look at the General Catalyst (GC) offering. From their site:

Traditional debt and variations of it such as ARR financing, credit lines, or revenue based financing can be a cheaper source of capital, but are not designed to fund S&M, for the simple reason that debt has to be repaid or refinanced on a fixed schedule. The payback on S&M is variable in nature, but a company’s debt repayment is typically fixed. 

GC argues that with revenue-based financing the business has to pay a percentage of revenue regardless of results. Customer acquisition doesn’t have a linear outcome (e.g. some quarters are better than others for a variety of reasons), so ideally they payback would flex with results and not be fixed.

Continuing from the GC site:

GC pre-funds a company’s S&M budget. In return, GC is entitled only to the customer value created by that spend, and GC’s entitlement is capped at a fixed amount. After GC reaches that fixed amount, the remaining lifetime value of the customers is the company’s to keep forever.

Sales and marketing (S&M) is often 50%, or more, of the annual budget — a huge percentage for most startups. In this passage, GC talks about funding that budget (loaning the money) in exchange for the “customer value created.” That piece isn’t clear. Is that the enterprise value of an incremental $1 of revenue? Something else?

Let’s assume it’s some multiple of new customer revenue, like 4x. If GC funds $10M of customer acquisition costs (S&M spend), and that returns $5M in new customer revenue, then GC would get paid $20M (a 2x return on the loan). Of course, there’s a wrinkle with how to allocate what new revenue came from that new spend vs previous spend as well as second order sales from brand, word of mouth, etc. The easiest answer is the most likely: all new customer revenue gets counted. 

Finally, from the GC site:

GC only gets paid if and when the company gets paid.

This is a nice touch — only pay down the loan when the cash comes in from the new customers. Aligning cash flow with funding is a great feature.

The other question is over what time period and at what rate does that “customer value” loan get paid back. My guess is that it’s over 5-7 years based on a percentage of that new customer revenue (e.g. add $5M in new annual revenue, 50% of that amount paid towards the debt until the customer churns or 2x the original loan is paid).

It’s great to see more innovation in the non-dilutive SaaS financing space. Entrepreneurs would do well to consider all their financing options, and not just venture capital, when looking for ways to grow faster. Hopefully customer value financing catches on and becomes more popular.

Update: A friend reached out and said it doesn’t work the way I thought from GC. He said that GC effectively does a new loan each month of ~80% of spend and it’s paid back with the revenue of the customers signed that month with a target interest rate of 12-14% repaid in 12-18 months.

3 thoughts on “Customer Value SaaS Financing

  1. Hi – I co-head the Customer Value Fund at GC. A few corrections: we fund up to 80% of a company’s S&M spend and set a target cap from the gross margin of the cohort acquired in that month/quarter. If the cohort performs as expected, we make the spread. If it doesn’t, we own the risk. Because we own the risk, we don’t have a fixed timeline to being paid back or a fixed cost of capital. However, we do have a maximum cap on the cost of capital in that the company will never pay more than our target return, but it may be lower as we own the risk. Companies we work with have S&M paybacks as short as 9-12 months or as long as 36-40 months. We are largely agnostic to the length of the paybacks as long the unit economics make sense for the business and there is lifetime value to support the S&M paybacks they are targeting. In fact, in many cases we encourage our companies to increase S&M spend (and hence paybacks) as they have the lifetime values to support it but have historically been balance sheet constrained or didn’t want to continuously dilute themselves.

  2. I absolutely adore the rigor within this approach… the accountability…

    Solid write-up that is augmenting how I think about this process of broader M&S spend

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