At Espresso our goal is to bring venture debt into the venture capital mainstream. One of the ways we do this is by funding companies earlier in their growth cycle than our counterparts, and another is by funding companies that lack institutional venture capital sponsorship. At the earliest stages we provide venture debt in the form of tax credit financing and, as our clients grow, we offer venture debt in the form of revenue financing to qualifying companies.
Our revenue financing is focused principally on SaaS and other sticky, high margin, subscription revenue based companies. The target market and business model figure prominently in our evaluation process, so in the interest of providing practical guidelines, this post will focus on business to business SaaS companies.
Before diving into the details, it is worth noting that usage of venture debt by technology companies is still in its infancy. Not surprisingly, when and how venture debt can be used beneficially is poorly understood. While the very best institutionally sponsored companies regularly leverage equity financing with venture debt, they make up less than 1% of the overall technology ecosystem. For context, it is worth noting that mezzanine financing (the equivalent of venture debt for later stage companies) is a very significant source of overall funding, and costs approximately the same as its venture debt counterpart.
Once a SaaS company has proven predictable and profitable customer acquisition and achieved minimum operational scale, its risk profile should have improved materially, and the business may be able to support venture debt. Notwithstanding the fact that it will likely continue to consume significant cash to fuel revenue growth, the reduced uncertainty in predicting future performance and ability to use a more data-driven and scientific approach to business management means the business is less risky than what its income statement would suggest. Espresso is not alone in viewing SaaS companies as less risky relative to their P&L performance. A recent Andreessen Horowitz blog post, Understanding SaaS: Why the Pundits Have It Wrong, provides detailed justification for lofty SaaS company valuations (which inherently entail lower discount or risk rates).
The reasons why a SaaS company should consider using revenue financing include:
Lower cost of capital: waiting longer and building greater critical mass will result in a higher valuation or better still, a higher valuation multiple than an equity financing today, and therefore lower net dilution;
Quick access to funding: equity financing typically takes six to nine months to close, and regardless of whether a SaaS company opts to embark on an equity fundraising effort now or in the future, venture debt funding, at least from Espresso, can be applied to sales expansion investments, and therefore shareholder value creation, almost immediately;
A funding alternative when equity is not available: many very good SaaS companies, for a variety of reasons, do not attract institutional venture capital interest, so venture debt represents an alternative form of sales expansion capital.
The starting point in our evaluation is determining if a given SaaS company has achieved predictable and profitable customer acquisition AND minimum operational scale. While the first two garner lots of press, as a venture debt lender the third criterion is equally important to us, and worth elaborating on. Minimum operational scale in essence is the level of monthly recurring revenue required to operationally break-even before sales expansion investments. This varies greatly amongst SaaS companies, and depends on a variety of factors including gross margin, customer acquisition cost efficiency, customer churn, customer lifetime value, product development intensity and overall operational efficiency. The Andreessen Horowitz post listed above, and an earlier article by David Skok, Saas Metrics 2.0 – A Guide to Measuring and Improving what Matters, are great reference sources on some of the essential metrics used by leading SaaS investors and SaaS companies to measure performance and manage growth investments.
Once a company has achieved operational scale, the pace of value creation accelerates as each net new investment dollar generates more recurring revenue and hence enterprise value (present value of future cash flows) than it did previously. Looked at another way, some of the extra return generated in each period that no longer needs to be applied to cover operational burn can now be used to service debt, and the growth in the stream of future cash flows provides the means with which the debt can be retired in the future, either via amortization of the principal or a balloon payment upon refinancing of the future cash flows (be it via senior bank financing, cheaper venture debt refinancing when the business is larger and even less risky, and/or equity financing).
For Canadian SaaS companies, particularly those that are not quite ready to attract US venture capital, there is an added reason to consider venture debt – scarcity of equity capital. While in recent years the absolute size of the equity venture capital pool in Canada has grown, so has company formation, meaning that Canadian companies remain capital constrained until they are big enough to attract US venture capital. SaaS companies that have reached minimum operational scale should consider Espresso’s revenue financing as part of their growth capital mix.