Software-as-a-Service (SaaS) has changed the way businesses operate on a global scale. We’ve seen small, hungry SaaS businesses enter the pantheon of massive, global companies (Salesforce, Slack). We’ve also seen some of the biggest traditional companies in the world pivot to SaaS with products like Adobe Creative Cloud. And it’s really no wonder why.
With significantly less overhead, easier distribution at scale, and better control over updates, cloud-hosted products with month-to-month payments have become the new standard expected by consumers.
Now, the next generation of impactful SaaS businesses are being built and how funding works for SaaS businesses is also evolving.
The funding landscape for SaaS businesses today
Gone are the days where banks ruled with dominion over the financial needs of businesses. Funding options for SaaS businesses are becoming more and more diverse by the year. That’s why we’re covering all of the available options for financing SaaS businesses in 2021 with an eye on how they line up against each other.
By laying out institutional venture capital, angels, banks, friends and family, as well as revenue-based financing, you will be able to lock in the funding solution, or mix of funding options, that prioritizes your needs.
Only in the last 5 years has revenue-based financing burst onto the scene in tech. For SaaS founders that are beyond product-market fit, generating revenue, and seeing modest to high growth, revenue-based financing offers a middle ground funding option between equity investing and interest-based bank loans.
Unlike venture capital investments where there’s an imperative to exit or go public to generate returns, returns are determined in advance with each funding agreement. As is the case with us, that means our returns are capped at 1.2x to 1.9x the funding amount.
And compared to typical fixed-payment, interest-based loans, flexible royalty payments allow your repayments to scale with your cash flow. So in the case that your revenues dip momentarily, you don’t have to worry about a fixed payment cutting deep into your cash reserves, prohibiting you from reinvesting or covering basic operating costs.
Overall, revenue-based financing has found traction in tech recently because it tends to be more inclusive than typical venture capital investment targets. The venture capital imperative for large markets and extremely-high growth rates means only that type of company fits the profile.
To dive deeper into the mechanics of revenue-based financing, check out our other article: Revenue-based financing 101.
Early-stage venture capital
For decades, venture capital has been the primary form of financing tech companies. And there’s a good reason for it. Where revenue-based financing requires product-market fit, cashflow, trending growth, venture capital investors shoulder large risks, especially when investing in SaaS businesses pre-product and before product-market fit. At this stage, a business is still primarily an idea and venture capital firms are effectively betting that the founders have the wherewithal to execute and capitalize on their opportunity.
In equity investing, you will have to trade some of your ownership of the company in exchange for capital. And there are pro’s and con’s to that. It can mean that investors are fully aligned with the company’s growth, and kick the company into overdrive by introducing potential strategic hires, sales opportunities, or other investors for future fundraising efforts. Doing so helps ensure that shareholder value increases for everyone, founders and investors alike.
There are disadvantages to venture capital as well. The cost of capital, something we’ll address below, can be very high. This means that the cost of selling equity can be even greater than revenue-based financing. Equity investing also means giving up board seats to investors, something that can lead to battles over control for the company if there is a misalignment between executives and investors.
Overall, this is why having trust in your investors is paramount to long-term success in venture capital.
Interest-based loans from banks
With interest-based loans, traditional banks don’t often work with early-stage SaaS businesses – too risky with little to no hard assets to leverage as collateral. This type of funding can be a much better fit for later stage businesses. Even still, interest-based loans aren’t generally considered overly competitive or attractive by many SaaS founders.
In part, the personal debt guarantees can be burdensome– the last thing you want is to have to worry about the bank seizing your private assets if the company folds. Banks also tend to require debt covenants, which mandate a certain amount of money maintained in the company bank accounts. This can hamstring your ability to invest capital in your team or sales efforts for growth purposes.
Friends and family fundraising
Compared to revenue-based financing, institutional venture capital, angels, and bank loans, fundraising from friends and family is typically a much more casual journey for founders. That’s because you have history with these potential investors – you’re already an insider. Communication oftens occurs without many hiccups, getting to a yes or no is usually fast, both of which make this type of funding preferable for many entrepreneurs.
There are a few things to bear in mind though here. Friends and family rounds are generally reserved for the first investments in the company, where check sizes are “relatively” small. This can range anywhere from $1-2,000 to $25,000 per investor, depending on how deep the pockets of your network are. And therein lies another major aspect of friends and family rounds – you need to already have affluent connections to make it work. And that’s simply not feasible for every founder.
If you can pull off friends and family rounds successfully, we recommend doing all fundraising by the book. Even though investors are close connections, hire a lawyer familiar with equity financing in tech and sign term sheets with all investors. This will ensure that everyone is on the same page and eases any future fundraising efforts.
As alternatives to venture capital and traditional bank loans have gained popularity over the last 5+ years, so has a return to the “oldest” form of building a business: bootstrapping.
More and more SaaS companies have bootstrapped successfully to $1-10m+ ARR, etching out space for what some venture capital investors think of as “Non-VC compatible” SaaS. We’ve also seen some notable venture funded SaaS businesses revert back to full private ownership, effectively bootstrapping, like Wistia, Buffer, and Sparktoro.
The journey can be notably more difficult this way, since the speed to get to revenues and profits is paramount in success. It’s not enough to simply see cashflow here, you need to push your company to create profits over a fairly quick period of time – usually within 1-2 years. The imperative for immediate profitability is notably less for many venture funded startups, where growth generally serves as the top priority and monetization comes after the product, business model, and sales strategy are all settled.
Beyond the immediate challenge of generating revenues, bootstrapping has serious advantages. You never have to worry about the fundraising process taking you away from duties to your team and customer, and moreover, you can maintain ownership over your business. Of course, bootstrapped companies that find sustainable growth or larger opportunities to pursue can always seek outside investment later.
The optionality to stay fully founder-owned, sell some equity, take on an interest-based loan, or receive revenue-based financing support is always in your hands.
Calculating the cost of capital
Between venture capital, venture debt, bank loans, and revenue-based financing, it can be a challenge to understand how the costs of capital compare. Frankly, they all differ so widely that figuring out how to make it apples to apples is the first step. That’s why we recommend using a framework for cost of capital analysis like an annualized cost percentage (ACP) number.
This simple formula is a great way to create an accurate comparison to understand how much each form of financing will cost you on an annual basis. Though not a perfect calculator, this method will give you a much better sense of how all your options stack up against each other and most importantly, how much each will impact your business.
Choosing the right funding option is all about your priorities
At Novel, we’ve been in the trenches. Each member of our team has first-hand experience with early-stage technology companies and the challenges entrepreneurs face. That means, we know that choosing the right funding solution for your SaaS business is never easy.
As we do with all the founders in our portfolio, we’re here to help and always happy to connect with you to discuss what makes the most sense for your needs. If you’re thinking through funding options for your SaaS business, then fill out the form on our homepage. We’d love to set up a call!