Last year I wrote about the need for a new kind of financing in Credit Crisis? A good time to finance SaaS products with debt. Recently, a company called Cap-Idea saw the article and contacted me to tell me about their debt program for SaaS companies. So, we are making some progress toward the goal.
In the good old days of fat enterprise software contracts, customers paid big chunks at the time of the initial sale. The move to subscriptions, which take years to deliver the same amount of cash, has shifted the burden of funding technology development and servicing away from customers ( who are often large companies with access to bank financing), to vendors (who are often smaller startups). This is economically awkward. Now the vendors need financing.
One option is to be as cheap as I am, with overhead + G&A at 3% of revenue. I don't recommend that you try that at home, or even at the office. I was a lot more profligate when I could talk customers out of big contracts, or when (ouch) I raised VC money. With customer financing being phased out of the business model, and equity financing hard to come by, it's time to bring out debt financing.
Debt financing works because SaaS companies are excellent credit risks. They have relatively fixed revenues (usually rising, but moving only incrementally), and variable costs. Major costs are typically discretionary development and marketing expenses. So, they always have the option of cutting expenses and keeping enough cash to make payments on debt. This makes them much better credit risks than industrial companies that often have fixed expenses, but variable revenue.
But, who will lend? The banking system is designed to lend against real estate. They do idiotic things like lend for no-money-down teaser-interest-payment-only mortgages, but they get away with it because all of the other bankers are doing it. By tradition, they accept real estate as collateral. They can also lend against assets like receivables. However, they have never considered software to be an asset that can serve as collateral.
A well-run SaaS company doesn't have receivables to borrow against. It's likely that they collect at least one month in advance, or as the bankers say, they have “negative days outstanding”. However, they do have the next month's or the next year's subscription revenue coming in, very reliably. So, a SaaS debt financing is usually stated as a loan that is justified and backed by subscription revenues, and a lender would typically lend approximately 3 month's revenue.
Cap-idea
Cap-idea says they want to lend $500K to $5M to companies that have $2M to $30M in annual recurring revenue. A typical deal would provide financing equal to three months of revenue. They say they have a standard term sheet. In many casese they will ask for warrants, although they are happy if they are dealing with an entrepreneur who is running the business for cash, and not to cash out warrants. If your business fits into those criteria, I suggest that you give them a call or email info@cap-idea.com and try out the deal.
Cap-idea was started recently by two guys that formerly ran a SaaS business. They really believe in the power of recurring revenue. They say their funding is from individual investors who understand the technology business. They have attracted that funding by observing that SaaS companies are more financially stable than perpetual license vendors, at low revenue run rates. They use the following simple chart to illustrate this argument.
There are a couple of reasons for lower risk. First, they have recurring revenue. And,they have reported less of the available revenue. If you think of a customer as a gold mine (my customers are laughing at this thought), the less you have removed from the mine, the more remains in it.
SaaS companies are more financially sophisticated at low revenue run rates. For example, they often have very sophisticated programs to increase their average revenue per customer, and they might test them on 1000 customers at the point where they are getting $1M/year. At the same level of revenue, and old-style enterprise software company would probably be in the “I met this guy at a conference” level of customer acquisition.
SaaS Capital
SaaS Capital was a venture-funded startup that was trying to do the same thing. Last year I talked to former EVP Bill Rurode, and he shared a lot of things that they learned. It sounded like a smart operation. I'm going to share two slides here the are the property of SaaS capital. The first shows that a serious SaaS company tends to burn even more cash than the guys that used to sell "perpetual" licenses, because it takes them longer to get money from customers.
The next table proves my point about SaaS companies being good credit risks beause they have variable costs. SaaS Capital imagined a company with $5M in subscription revenues, cutting development and marketing expenses, and being run purely for cash. This generates an amazing $3.3M in cash flow. The slide is a little big for this blog column, but worth it.
Unfortunately, SaaS Capital closed down during the financial crisis, in the fall of 2008, because they couldn't raise money to fund the loans. This may have been bad timing – it was the worst possible time for a financial institution to seek money – but it also reflected a structural problem. They weren't a bank, and they didn't have access to the incredibly cheap funding that banks have been getting.
Silicon Valley Bank
SVB is a bank, although they are different from most banks, with services that are designed for small, VC-funded companies. I spoke with Dan Allred there, who told me about their program for lending to SaaS companies. He rattled off almost the same terms as Cap-Idea. They will lend 3 months revenue, with a $500K minimum, asking for warrants if the company is still losing money. According to Dan, "We don't have standard term sheets. We like to think that is why we are important to the industry. We will evaluate each business individually, and tailor something to meet their needs." I hope that we hear back from some readers who test SVB on this offer.
Dan asked "Is is this really software, software as a service, the high margin stuff? Or is it really 'service as a service?' And, is it mission critical for the customer?" Those are good questions to ask in order to determine the value of your service and your business.
Citizen's Bank – the Walk of Shame
I decided to make a small test of my current bank – Citizen's Bank. I asked them for a $10K equipment loan. This should have been a no-brainer for them, because Assembla has been a good customer for four years, and we keep $300K in a deposit account earning essentially zero interest. This is a best case scenario from a banker's point of view, although silly on my side. I give them money, and they loan it back to me with fees and interest charges. They sounded pleasant enough at first, and they gave me forms to fill out, and asked for financial statements and tax returns (that's moving out of friendly to businesslike), and then asked for a personal guarantee (starting to sound a bit suspicious by then). After all that, they killed the deal through the simple mechanism of not responding, and not returning my calls. What this means is … they aren't actually making small business loans. They are just PRETENDING to do it to, because that's what they have to do to justify getting free money from the Fed, TARP and other subsidies from the US government, and a huge bailout. Citizens is a division of Royal Bank of Scotland, which recently sucked up a $74B bailout from the British government, the biggest bank bailout in the world.
Citizen's does a good job sending our bank wires, but won't lend to small businesses, and is in fact deceptive. I'd like to think that I am not encouraging bad behavior by supporting Citizen's Bank and other institutions like them, so I guess I should initiate a move. Citizens, you have been put on notice. Walk the walk of shame.
The importance of scale
Scale is important. A small software company with good fiscal management can't get a loan, but a giant bank with bad judgment and terrible losses pulls in tens of billions of dollars. The guys that originate the loans only earn a small percentage fee, which is proportional to the size of the loan. To make a living, they need to lend out at least $500K at a time, and ideally they want to lend out several million.
To access financing that covers the next three months of subscription revenues, you should have revenues of at least $2M/year, or a run rate of at least $200K/month. That's not much in most businesses, but in the Web 2.0 world, costs are low, and $200K/month might represent five thousand customers. If you put a couple of $100K/month products together, all of a sudden it's a good prospect for a lender. So, I expect to see a lot of mergers, acquisitions, and even rollups as small companies band together to get better and better financing terms.
Standardization?
Standardization is the one ingredient that can make any debt market expand many times, the way that mortgage debt and credit card markets expanded. If there is a standard term sheet and a shared understanding of collateral, it will allow bankers to quickly justify these deals to the other bankers who fund the deals. This will drive down the minimum size of the deal, drive down costs, and expand the amount of money available. So, that is the next step.