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.

5 Variables for a Quick SaaS Valuation

SaaS continues to be hot and shows no signs of slowing down. Of course, the strong gross margins, excellent recurring revenue, and overall predictable nature of the business model make it worthy of its praise. These same characteristics also provide the fundamentals for quickly assessing a rough valuation of the business as outlined in Premium SaaS Metrics Required for Premium Valuations.

After feedback and questions on that simple valuation, it’s clear there’s appetite for a slightly more complex formula whereby a couple additional variables are introduced.

The first variable to add: gross margin. As you can imagine, a SaaS company with 90% gross margins (extremely low cost of goods sold) is substantially more valuable than a SaaS company with 60% gross margins (high cost of goods sold for SaaS). A gross margin that’s 50% higher should be reflected in the valuation of two otherwise comparable SaaS businesses.

The second variable to add is much fuzzier: market sentiment. Sometimes SaaS is hot. Sometimes SaaS is white-hot. The fastest way to assess this market sentiment is through the public markets. Take the BVP Nasdaq Emerging Cloud Index and pull an easy-to-consume revenue multiple. That is, looking at all public SaaS companies, what’s the enterprise value divided by the revenue. This revenue multiple is the fastest way to gauge market sentiment. Today, that number is 12.6. Wow!

In the previous formula there was a generic 10x multiplier. This multiplier is better represented by the market sentiment.

Now, here’s the slightly expanded formula:

Market sentiment x

Annual recurring revenue x

Growth rate (use trailing twelve months) x

Net renewal rate x

Gross margin =

Valuation

Let’s take a look at an example using today’s market sentiment multiple of 12.6.

12.6 x

$3M in ARR x

70% TTM growth x

100% net renewal rate x

80% gross margin =

$21.2M valuation

Naturally, for an imperfect market with a limited set of buyers and sellers, this valuation formula is merely a directional number as each startup is unique. For entrepreneurs wanting to understand how to think about SaaS valuations, this basic five variable equation is immediately valuable.

Premium SaaS Metrics Required for Premium SaaS Valuations

When talking to SaaS entrepreneurs, inevitably the topic of valuations come up. Right now, public SaaS companies are trading at all-time highs, so entrepreneurs expect those valuations to apply to their startups. While the valuations of public and private SaaS companies have a direct correlation, it’s important to understand that not all SaaS revenue is created equally, regardless of public or private markets, thus valuations as a function of revenue vary wildly.

As expected, premium SaaS valuations are driven by premium SaaS metrics. Here are a few of the most important ones:

  • Annual Recurring Revenue – The annual run-rate is the most talked about SaaS metric. Ensure that it’s contracted, recurring revenue as different from other revenue sources like services revenue and payment processing revenue.
  • Gross Margin – The money left after the cost of goods sold are taken out. SaaS company gross margins vary dramatically from the low 60s to the high 90s. Anything below 60% gross margins isn’t SaaS (startups masquerade as SaaS but often aren’t). A SaaS company with 90% gross margins is 50% better than a SaaS company with 60% gross margin, and correspondingly much more valuable per dollar of revenue.
  • Growth Rate – The year-over-year growth rate reflects the potential to continue growing fast, and ultimately achieve a much greater scale in the business. Investors pay a huge premium for high growth.
  • Net Renewal Rate (also Net Revenue Retention) – The gross renewal rate plus upsells and cross-sells represents how the annual recurring revenue will change assuming no new sales. Investors pay a huge premium for high net renewal rates.

Directionally, the simplest formula for SaaS valuations is as follows:

  • 10 x
  • Annual recurring revenue x
  • Growth rate x
  • Net renewal rate =
  • Valuation

Here’s a quick example:

  • 10 x
  • $5 million in annual recurring revenue x
  • 50% growth rate x
  • 105% net renewal rate =
  • 10 x $5,000,000 x .5 x 1.05 = $26,250,000

So, a $5M SaaS company with good growth and good net renewal rates would be worth a bit more than five times annual run rate.

To make it more complete, you’d add in gross margin and elements to reflect more nuanced variables like the potential size of the market (e.g. a valuation premium for bigger markets).

One SaaS company might be worth 15x run-rate (due to high growth rate and high net renewal rate) while the next one might be worth 2x run-rate (due to no growth and high churn).

Premium SaaS metrics are required for premium valuations. Look at the entire picture, not just annual recurring revenue.

Compounding Revenue’s Value in the Future

When talking to entrepreneurs about revenue growth, I look to emphasize the value of compounding revenue now and how it plays out over an extended period of time. It’s easy to think that it’s no big deal that we missed our sales number for the quarter or had a lower renewal rate than expected. Only, when you really dig in, a lost dollar today translates into many lost dollars of revenue and enterprise value over the long run. Similarly, an extra dollar of revenue sold today translates into much more revenue and enterprise value over time.

Let’s look at an example. Say you were able to beat the sales plan and the net dollar retention plan adding an additional $1 million in new recurring revenue in a calendar year. With an extra $1 million in recurring revenue:

  • Year 1 after exceeding goals
    • Extra ~$800,000 to grow the business (assume 80% gross margin)
    • Hire two additional sales reps and increase marketing spend (assume 50% of the extra $800,000 goes to sales and marketing)
    • Add $1M of new annual recurring revenue from the new reps (assume the two reps each have a $500,000 quota and hit it)
  • Year 2
    • Extra $1,600,000 to grow the business (year 1 gross margin plus the gross margin added by the new reps assuming 100% net dollar retention)
    • Hire four additional sales reps and increase marketing spend
    • Add $2M of new annual recurring revenue from the new reps
  • Year 3
    • Extra $3,200,000 to grow the business (it keeps layering on the previous year!)
    • Hire eight additional sales reps and increase marketing spend
    • Add $4M of new annual recurring revenue from the new reps

In this example, by the end of the third year after the year of an extra $1M in annual recurring revenue, the business has added $8M of new annual recurring revenue. $8M of annual recurring revenue pays for dozens of employees and adds $40M – $80M of enterprise value in today’s market (assumes 5-10x run rate multiples).

The next time someone questions the importance of renewing an existing customer, or signing a new customer, remind them that $10,000 of recurring revenue today is worth up to $800,000 of enterprise value after three years. Every dollar counts.

The Email Inflection Point in the Product/Market Fit Journey

When we launched the initial marketing automation product for Pardot, the feature set was quite simple. We had a minimal analytics that would track the individual lead’s movement around the site, a basic form capture to collect contact information, rudimentary CRM integration to sync data, and that was about it. Over time we added core modules like landing pages, automation rules, complex CRM integrations, and dynamic customer journeys. Only, the initial plans didn’t call for email marketing.

In fact, we actively didn’t want to do email marketing. Who wants to be an email service provider (tools like Sendgrid didn’t exist then)? Who wants to deal with deliverability? Who wants to fight spammers? The initial strategy was to have integrations to Mailchimp and Constant Contact such that modules like the forms manager could trigger an autoresponder and an automation rule could trigger a 1-to-1 email.

Quickly, we realized something was wrong.

Our approach delivered a poor, incomplete experience to our customers. Email was too important to be siloed from the marketing automation system. Email was too powerful as a marketing channel to not be a first-class module.

After endless internal debates about email, we finally decided to become an email service provider. Now, we enabled email to be a core feature throughout the platform. Now, marketers didn’t have to switch between as many different systems to run their marketing programs.

Email was a major inflection point in our product/market fit journey. Prior, customers liked the software but our product/market fit was modest. After adding email marketing, and a few rounds of refinement, our product/market fit was excellent and customers raved about the solution.

Major strategy changes often seem daunting. By focusing on the customer, and going down a much more difficult path technically, we delivered a superior experience. And, in the end, that was one of the most important product decisions we ever made.

When the Opportunity is Bigger Than Expected

Three years into Pardot we were humming along and had just cracked the $1M annual recurring revenue milestone. Customers were loving the product and saying things like, “I don’t how I did my job before using Pardot” — a great sign we had a must-have product, not a nice-to-have. After listening to customers talk about the value they received, internally we started debating raising the price to match the value.

Then, of course, worries emerged:

  • Would prospects pay the higher price?
  • Would sales cycles lengthen?
  • Would sales velocity slow down?

And, naturally, the sales reps didn’t like the idea because they feared they’d make less money.

After getting internal feedback and input we made the call and doubled prices. What happened next was unexpected: sales and revenue grew even faster than planned.

At that point, it dawned on me the opportunity was bigger than expected.

Marketing automation was a billion dollar market in the making.

We were at the right place, at the right time, with the right team.

But, honestly, at the start of Pardot we thought it was a decent idea but didn’t know if it was good or great.

We didn’t know if the timing was right.

We didn’t know if the Great Recession would slow us down.

Three years into the business we knew we were on to something big — even bigger than expected.

Reforecasts and Communication

Two years ago I was sitting down with an entrepreneur debating what to do next. It was early in the hyper growth stage of the startup and things were growing fast. Only, with limited operating history, growth expectations were even greater than reality, and there was no way the annual forecast was going to be achieved.

Accountability was tied to the forecast.

Goals/OKRs were tied to the forecast.

Bonuses were tied to the forecast.

What to do?

This challenge is much more common than expected. Fast growing startups are inherently unpredictable. Even with bottoms-up and top-down forecasts, reality is different from the spreadsheet. At some point, trying to hit a forecast that is no longer possible is more demoralizing than motivating — it’s time for a reforecast.

A reforecast is simply redoing the budget and expectations after the year has already started to reflect new information. The key is to get all the stakeholders together, work to make the new forecast as accurate as possible, and then communicate it with the team.

Communication is the most important part.

By over-communicating, including why the reforecast was necessary, learnings from the experience, and go-forward expectations, team members are more bought in and more accepting of the changes. People don’t expect leaders to be perfect; people expect leaders to lead and be transparent.

Reforecasts are part of normal startup life. They shouldn’t happen yearly, but they do happen in the normal course of business. When a reforecast is necessary, make the changes and over-communicate with the team.