The Rise of Revenue Financing Loans for SaaS

Recently, several entrepreneurs have asked me about revenue financing loans. Revenue financing is a fancy way of saying a semi-complicated loan where payback is dictated by a number of elements including a percentage of revenue, not just a traditional interest rate. The good news is that it provides for a more aggressive, non-dilutive (usually) form of financing for Software-as-a-Service (SaaS) companies. The bad news is that it’s much more expensive than a bank loan, but still not nearly as expensive as venture capital.

Here’s how an example revenue financing loan might work:

  • Loan amount equal to 20% of current annual recurring revenue (e.g. $10M in ARR, $2M loan)
  • Loan covenant where one month’s operating costs in cash required on hand at all times (e.g. $800k of monthly expenses, with a $2M loan, only $1.2M can actually be used)
  • First 18 months interest-only monthly payments (on the full $2M, not the usable $1.2M) where the “interest” is 3% of the monthly cash receipts (hence the name revenue loan as the interest rate is directly driven by the revenue of the business)
  • 3.5 years of equal principle payments after the first 18 months plus the continued interest of 3% of the monthly cash receipts (so, the loan is paid back after five years and the interest payments keep rising assuming revenue keeps growing)
  • Additional 10% of original loan amount payment due after final payment or at time of next financing event (payment can be cash or equity)
  • Minimum of 1.7x the original amount back to the loan provider with a max of 2.5x (since the interest rate is a percentage of revenue, if the business grows faster than expected, the interest rate could be much higher and up to 2.5x would be paid back)

Wow, it is complicated! Net net, it’s roughly a 25% interest rate loan with variability based on how fast revenue grows. SaaS, with its amazing margins and cash flow predictability, makes this type of financing uniquely suited to both the investor and the recipient, especially compared to most types of other businesses.

SaaS entrepreneurs looking to grow faster, but reluctant to sell equity, would do well to talk to the newish crop of revenue financing firms out there.

What else? What are some more thoughts on revenue financing loans?

Raising Venture Capital Isn’t Right for Most Entrepreneurs

Earlier this week I was on a panel at the excellent 36|86 Entrepreneurs Festival in Tennessee talking about bootstrapping vs venture capital. Reflecting on the panel discussion, and other conversations at the event, it’s clear that raising venture capital is still viewed as too much of a default path for tech entrepreneurs. In reality 99% of entrepreneurs, tech or otherwise, shouldn’t raise venture capital.

Here are some of the common reasons raising venture capital isn’t right for most entrepreneurs:

  • It limits exit opportunities
  • It puts a timeline on the business
  • It requires a 5x greater exit for the founder to make the same money
  • Most markets aren’t winner take all

Beyond the common reasons, the reality is that most entrepreneurs can’t raise venture capital because they don’t have enough traction (revenue!), growth (much be growing super fast), unit economics (strong gross margins and profit possibility), and market opportunity (must be a huge market). Too many entrepreneurs spend time trying to raise institutional money when that time is better spent building the core business.

The solution: find a trusted advisor or mentor in the community to help think through financing options. Most of the time venture capital isn’t the right path, and isn’t even an option due to the business characteristics.

Entrepreneurs would do well to better understand venture capital and know that most of the time it doesn’t make sense.

When SaaS Valuations Weren’t So Rosy

With Thomasz Tunguz’s recent post The 5 Forces Driving Startup Valuations Today it reminded me that SaaS valuations weren’t always so rosy. Today, the median forward multiple for public SaaS companies is 8.5x (meaning, these companies are valued at 8.5x expected revenues).

10 years ago we were out actively raising money for Pardot after hitting $1M in annual recurring revenue. We met with 29 different venture firms in Atlanta, D.C., Boston, and Silicon Valley. After being turned down several times with the message that the total addressable market for marketing automation was too small (hah!), we had three interested parties that floated valuations and wanted to talk potential term sheets.

By the time of these advanced conversations, we had $1M in trailing twelve months recognized revenue, $1.3M annual run rate, and 300% growth rate. Here were the verbal offers:

  • $500,000 investment at a $2M pre-money valuation
  • $1M investment at a $2.5M pre-money valuation
  • $5M investment at a $7M pre-money valuation

After doing some spreadsheet math it became clear that we were better off not raising money and continuing to go it alone. We decided not to raise money and kindly discontinued conversations with the VCs. If the valuations back then were what they are today, the spreadsheet math would have likely turned out differently.

Know that SaaS valuations have never been better but that we’re in unusually good times — it wasn’t that long ago when they were substantially lower. Still, do what’s best for the business and don’t raise money just because valuations are high.

What else? What are some more thoughts on SaaS valuations?

3 Alternative SaaS Funding Strategies

One of the things I love about startups is that every week I’m learning something new. Naturally, there’s no one way to do things and so entrepreneurs are always trying out different ideas and occasionally sharing them with the world. Earlier this week three different blog posts came out detailing alternative SaaS funding strategies a) Raise one time from angels ($1.3M) and might do more, b) Raise from multiple rounds but smaller amounts ($2.5M) each time depending on the progress of the business, and c) Raise a tremendous amount of money ($700M+) as quickly as possible over multiple rounds. Let’s dive into some of the highlights.

SparkToro Raised a Very Unusual Round of Funding & We’re Open-Sourcing Our Docs

  • “We believe that there’s room for a company that can be successful for its customers, employees, founders, and investors (generally in that order) without demanding a multi-hundred-million or billion-dollar outcome. We spent a lot of time discussing the frustrating binary (succeed on a massive scale or die trying) of the classic tech startup model, and how we might craft a creative structure that would allow for the potential of a huge outcome without forcing an unhealthy growth rate or a destructively impatient approach.”
  • Only raise from non institutional investors so that there’s no timeline
  • Investors initially expected to get their money back via dividends (1x non pref)
  • Keep optionality open to go the venture route but don’t drive towards that

Anatomy of our $5 million seed round

  • “SaaS companies do not require large amounts of capital all at once in order to fund expensive R&D, brand marketing, or giant sales teams. Instead, we require small amounts of capital over an extended period of time, in order to experiment and continuously push harder on the things that work. This is why most SaaS companies today should raise several smaller rounds of funding during their “seed phase” before raising a series A. The ideal funding for a SaaS company looks closer to an IV drip than a shot of adrenaline to the heart. We need more funding sources that understand this.”
  • Most SaaS startups don’t warrant the traditional VC model of go big or go home
  • Raise enough money each round to get to breakeven at another milestone
  • SaaS supports dripping in more modest amounts of capital and still producing great outcomes

Domo IPO | S-1 Breakdown

  • “Domo recently drew down $100M from their credit facility and currently only has ~6 months of cash left with their current burn rate. Given they raised $730M in equity capital from investors and another $100M through their credit facility, it implies they have spent roughly $750M over the past 8 years to reach a little over $100M in ARR, an extraordinary and unprecedented amount of cash burn for a SaaS company.”
  • Last quarter burned $40M to add $8M of new ARR
  • CAC of $430k with avg ACV of $67k
  • Median payback of 98 months

It’s great to see people detailing different funding strategies as there’s room for innovation and new ideas. Figure out what’s best for the business and execute accordingly.

Implications of Raising Venture Capital

Last week I was talking to an entrepreneur that was dead set on raising venture capital. Naturally, I wanted to understand more and asked a number of questions. Turns out, this entrepreneur just thought it was the next step to being successful. Venture capital shouldn’t be viewed as just another step in the startup journey — raising venture capital is a serious decision that shouldn’t be taken lightly.

Here are several implications of raising venture capital:

  • Growth – Startups are growth-oriented organizations. Raising venture capital takes the emphasis on growth and raises it to max — everything is focused on growth. If growth stalls, more money needs to be raised or the company needs to be merged with someone else that is growing faster. Grow, grow, grow.
  • Timeline – As soon as you raise institutional capital (as different from angel capital, family office capital, etc.) the business is now on a timeline to sell in as little as 3-5 years and as long as 7-10 years. No matter how you feel, the business has to be sold (or go public) in an effort to generate returns for the limited partners (the people and institutions that provide capital to the venture capitalists).
  • Partnership – Selling a piece of equity is signing up for a long-term partnership with the investor. The relationship should be viewed as a partnership and not merely as an investment. Only raise money from investors you want to work with indefinitely.

Raising venture capital puts the startup on a path to grow at all costs, and has serious implications. Most startups fail and most startups that raise venture capital don’t make any money for the founders. Entrepreneurs should deeply study the pros and cons of this type of capital and know that most of the time it doesn’t make sense. Yet, when everyone is aligned and the startup does well, it’s a beautiful thing.

Startup Success: Team, Stream, and Not a Meme

Over the years I’ve spent many hours trying to figure out why some startups are successful, and most are not. The goal: distill startup success down into as simple a framework as possible. Of course, startup success is hard and messy, but it’s helpful to have a high-level context for the over-arching components of success.

Alright, let’s get to it. The three components of startup success:

  • Team
  • Stream
  • Not a Meme

Team represents the group of people working together to achieve the mission. Some of the most important attributes are resourcefulness, grit, and determination. Startups are an environment of limited resources, repeated failure, and long odds. Most people don’t thrive in a startup. The best teams figure out what needs to be done and makes it happen.

Stream represents movement and speed whereby disruption is happening, and it’s clear that a new, better way is possible. The best streams are large, major shifts where entire industries are transformed. The more disruption, the more opportunity for startup success. Examples include the shift from offline advertising dollars to online, the shift from telephone lines to voice over the Internet, and the shift from field sales to inside sales.

‘Not a meme’ represents things that are must haves, not nice-to-haves. Memes are funny or witty quips that represent a cultural phenomenon. As an example, Chuck Norris has a number of memes around things he can do that no one else can. One of my favorites: Chuck Norris gets Chick-fil-A on Sundays.

Most startups build nice-to-have products and fail. Nice-to-have can be a product that isn’t valuable, a product that’s useful but in an over crowded market, or something that’s too far ahead of its time.

Let’s take AirWatch, an Atlanta success story that VMWare acquired for $1.5 billion. The original team was comprised of the Manhattan Associates (NASDAQ:MANH) founder and another executive that had worked together before. The stream was the rise of the smartphone and people bringing their own devices to work (major transformations). The ‘not a meme’ was companies needing to enforce security rules and policies across thousands of employees’ smart phones. All three components — team, stream, and ‘not a meme’ — were combined with a massive market.

The next time you evaluate a startup idea for yourself, or meet with an entrepreneur, ask these three questions:

  • Why is this team going to win in this market?
  • What fast moving stream is shaking things up and causing disruption?
  • How is the product ‘not a meme’ such that it’s a must-have for customers?

Answer the team, stream, and ‘not a meme’ questions correctly to predict startup success.

High End SaaS Valuations Using the 2017 Inc. 5000 Data

Every year I love pouring over the Inc. 500 (now Inc. 5000). When I first read Inc. magazine in high school in the late 90s, I made it a personal goal to win the award. As a founder/CEO, I first succeeded with Hannon Hill (#247 on the 2007 Inc. 500) and then with Pardot (#172 on the 2012 Inc. 500). And, now, as a co-founder/chairman, succeeded with Rigor this year (#430 on the 2017 Inc. 500).

When looking through this year’s list, a number of well funded SaaS startups appeared:

  • Gainsight – $23.1M, 3,843% growth, #102
  • Bizible – $3.4M, 2,405% growth, #179
  • Domo – $79.9M, 2,250% growth, #192
  • GuideSpark – $24.8M, 525% growth, #856
  • Smartsheet – $64.3M, 425% growth, #1021

Let’s take Gainsight as it has the highest growth rate and look at some high end SaaS valuations from their funding rounds.

Gainsight Notes

  • Funding rounds listed in Crunchbase:
    • May, 2017 – $52M Series E
    • Nov, 2015 – $50M Series D
    • Oct, 2014 – $25M Series C
    • Nov, 2013 – $20M Series B
  • Recognized revenue by year:
  • Estimated end of year run rate (run rate is always ahead of recognized revenue for fast growing companies):
    • 2016 – $30M
    • 2015 – $17M
    • 2014 – $8.5M
    • 2013 – $3.5M
  • Published valuations:
    • Nov, 2015 – $348M post-money (source)
  • Estimated valuation as a multiple of run rate:
    • Nov, 2015 – $16M run rate with a $298M pre-money valuation making a valuation multiple of 18.6 times run rate
    • Nov, 2013 – $3M run rate with an estimated $80M pre-money valuation making a valuation multiple of 26.7 times run rate

SaaS valuations are typically in the range of 3-5x run rate and can go as high as 10x run rate for the fastest growing startups (see SaaS Funding Valuations Based on a Forward Multiple). When valuations are 18 and 26 times run rate, it’s a bet on building the category winner and a different game compared to 99% of the venture capitalists out there.

Want to explore more? Check out the 2017 Inc. 5000 and Crunchbase.