Tech Lending: Software as a Service
This article is the fourth in a series providing an overview of critical considerations for commercial lenders contemplating whether to finance a tech company and how such loans can be secured.
What is SaaS?
With the rise of cloud-based computing, Software as a Service (SaaS) models have become leading players in the technology space. SaaS is a software licensing and delivery model in which users have remote access to software – or, more accurately, to the functionality of software. Users access the services online through an external server, as opposed to installing hardware locally. SaaS is often a subscription service; the customer makes regular recurring payments. Examples of SaaS companies include SalesForce.com, Google, MailChimp, SurveyMonkey, Adobe, Slack, Shopify, Dropbox and DocuSign.
Advantages of SaaS
Due in large part to the many advantages for vendors and customers, SaaS is quickly becoming the preferred software model. Vendors benefit significantly from economies of scale – services, technology maintenance and infrastructure are managed centrally, resulting in decreased marginal costs with each additional customer. Further, customers are automatically equipped with the latest version of the software, since updates are deployed to the user base as a whole from the main server, without requiring costly and time-consuming on-site installation. This also reduces implementation costs, as there is little to no software installation and no hardware installation. These cost savings increase margins for vendors and lower subscription rates for customers. There is the additional benefit to vendors that there are never users that fail to install maintenance “patches” and updates, because all patches and updates are automatic and implemented for all users at the source.
SaaS providers enjoy a lower churn rate of customers and heightened customer loyalty. SaaS customers are usually “stickier” than traditional software companies’ customers, particularly when the software is an integral part of the business. Not only does this create steady and predictable recurring revenue, but it also provides upselling opportunities.
These advantages contribute to the attractiveness of SaaS providers to lenders. Once a SaaS provider can prove predictable cash flow, risk is easier to anticipate and loan financing is more readily available. In the age of data storage, a centralized server model allows providers increased opportunities for data collection and insights, which lenders interested in value also find appealing.
Often, SaaS providers turn to equity financing as a means to raise capital. Venture capitalists can provide valuable expertise to navigate growth in the business and will typically have specialized knowledge and experience in the SaaS industry to scale operations. Compared to debt financing, venture capitalists have much higher risk tolerance and are better prepared to face rough patches. Debt lenders tend to be more risk averse. If things go awry, a lender may not stick it out with a SaaS borrower, leading to unpleasant results for the borrower.
Benefits of Debt Financing
Equity financing is an attractive means to raise capital, but there are many potential upsides to debt financing. Debt financing may allow SaaS providers to obtain debt funding where they may not have traditional “hard” assets to offer as collateral. Due to persistent recurring revenue, high growth potential and a lower churn environment for customers, SaaS providers often achieve high market valuations and, especially, high valuation of cash flows, which can sustain debt financing. Most capital expenditures occur in the early days of the company, primarily in developmental, operational and customer acquisition costs. This frontloading of expenses, coupled with recurring revenue, enables SaaS vendors to enjoy high profitability after break-even and high contribution margins. Where SaaS providers have specific assets to be financed – for instance, cash-flow streams and IP assets – debt financing will be easier to arrange.
Relative to equity financing, debt financing enables a SaaS vendor to receive a quicker influx of capital while avoiding equity dilution. Equity financing can be a lengthy process as it requires a higher level of due diligence and substantial negotiations. Unlike with debt, the return for shareholders is not defined, so there are a greater number of terms to agree on. Lenders see monthly recurring revenue as a key factor in supporting a repayment program, similar to lending to a landlord with leases. Equity financing, however, does not have the same level of predictability.
Finally, debt financing is generally non-dilutive, meaning that the incoming financing by way of debt does not require the issuance of shares that reduce the existing shareholders’ percentages of the company. (Note, however, that some debt financing involves warrants that do allow for the potential of some limited equity issuance.)
Characteristics of a Debt-Worthy Borrower
SaaS vendors can be very attractive to lenders under the right circumstances. SaaS companies who have been able to bootstrap to scale (i.e., have not taken outside funds and are not carrying other debt) are particularly attractive. It demonstrates they are capital efficient and have built the business with limited funds. When approaching lenders, SaaS companies should be scaled to at least minimum operational level, whereby each additional dollar invested yields more recurring revenue and the additional recurring revenue can be demonstrated to fully service the debt. The company must be established and operational to the extent needed to satisfy the debt. Once established, the borrower will have at their disposal several options to repay the debt. The debt may be satisfied through a high-value equity raise, which would only be possible if the SaaS borrower has already proven the business viability, or through amortization or balloon payment. The SaaS vendor must have a good reputation in the market as a provider, and it’s a bonus if they are highly regarded by banks, insurers and public companies.
SaaS providers are quickly rising in prominence in the technology space and lending opportunities are growing right alongside. SaaS companies have a potent business model which presents both challenges and opportunities for lenders, but they’ve proven they are here to stay.
If you require assistance with any matter or question related to commercial lending, including to SaaS vendors, please reach out to a member of our Financial Services Group.