The numbers are in.  VC investment is down 50% in the first quarter of 2009.  Equity investors are in no position to finance small SaaS startups.  And yet, it's a great time to invest in SaaS.  SaaS is one of the few markets that is still growing at 40% per year, and on top of that, it's a declining cost business with predictable cash flows.  If the VC's are out of the game (no cheering from the peanut gallery, please), where will the investment come from?  Partly, it will come from bootstrapping (that's what we do at Assembla), but I think a lot of it will come from debt financing.

Debt financing in a credit crisis?  I am not crazy.  Debt financing has emerged as a good option, or at least it should soon emerge with some financial R&D and some good old entrepreneurship.  In this article I will discuss the origin of the financing challenge facing SaaS companies, how the unique economics of these companies favors debt financing, and the potential profits from providing them with debt financing.

The origin of the financing challenge

Growing SaaS companies are often hungry for money because they are financing up-front costs, and getting paid over time.  It has always been true that software companies require some investment of money or sweat equity for product development, marketing, and sales.  The new twist is that subscription revenue models take longer to deliver cash than the old "perpetual" software sales.  Vendors may get as little as one month up front - typically 1/30 of what they would have received under the old perpetual model.  Studies of public companies show that, compared with earlier generations of enterprise software, subscription-based companies like Saleforce.com have taken longer to reach break-even and consumed more capital.  Web 2.0 style companies have partially solved this problem by having extremely low costs, but they haven't mnade it go away.

Customers and pundits have picked up on the fact that online software and subscriptions (software as a service) are inexpensive, partly because they can be paid monthly rather than in advance. But, they rarely look at the other side of the problem, which is that financing responsibilities have been pushed out from customers (often big, creditworthy companies) to the vendor.  Moving financing responsibility from the creditworthy to the credit-less seems ridiculous, a true problem for modern finance.

The financing need is not going to be filled by venture capitalists and other equity investors.  The VC market has collapsed.  In the lastest report, VC investments are down 50% year on year, and down even more for small, early stage software deals.  The VC product is companies that make long-term investments, or, to put it another way, money losing companies, clustered in a small number of volatile industries.  IPO investors and acquirers are refusing to buy the product, so the VC's have to stop making it.  Angel investments are drying up for the same reason, and because of stock market losses among angels. This is a bad time to sell equity. 

But, maybe it's a good time to be a startup SaaS company.  Demand for SaaS services continues to increase, with average annual growth rate estimates as high as 40%. 

SaaS and Software companies are less affected by the credit crisis 

I think it is unreasonable to call the current situation a credit crisis - a problem caused by a shortage of credit.  Interest rates are at record lows, indicating a surplus of money to lend.  Trillions of dollars have been released by the government and the Fed.  If you could tap into this money, perhaps, like Goldman Sachs, by placing your senior executives into the treasury department, you too could report record profits.

The credit crisis is really a debt crisis, affecting companies that borrowed a lot of money.  Those companies need to roll over their debt, and they can't, because their lenders have realized that they already borrowed too much.  Software companies do not have this problem because nobody will lend to them.  Since they haven't borrowed money, credit is available, or should be, at interest rates that are lower than ever.

SaaS companies typically do not have debt.  And, some of them are making money, because they often have very low costs.  This is particularly true if they can lower their selling costs by using online direct marketing instead of a sales staff.  Furthermore, the costs of the major inputs - code, servers, online marketing - are declining.  And, many of those costs are variable.

Uniquely favorable economics - Fixed revenue, and variable cost

Banks won't lend to software companies because they want collateral - assets with a known resale price.  They like real estate, factories, and inventory, which can be appraised, and they consider software to be worthless or of unknown value.  They need the collateral because they are lending to companies which tend to have fixed costs, and variable revenues.  If revenues decline, then the debt can't be repaid, which causes the banks to sieze and sell the collateral, or at least threaten to sieze it.  It's all very high risk if you are working with fixed costs and variable revenue.

SaaS companies offer uniquely favorable  economics. Instead of fixed costs with variable revenue, they have fixed revenue with variable costs.  SaaS companies can have very low fixed costs, with rental hosting, workers that are contractors or partners or both, and no real estate.  That's how Assembla works.  The fixed revenue is frustrating - it means that revenue grows slowly, but it also shrinks slowly.  Fortunately, this is a good situation for debt financing.  If a business needs to pay off debt, it can reduce expenditure on growth (typically development and marketing), and use the money to pay off debt instead.  Lending to a fixed-revenue, variable-cost business is much lower risk than lending to a fixed-cost, variable-revenue business.

Current borrowing opportunities for SaaS businesse

Assembla, like most subscription businesses, borrows from its customers. We offer discounts of 20% or so for advance payment, and significant percentage of customers take us up on this offer.  So, we have a "deferred revenue liability" - fulfillment services that we owe to customers in exchange for these advance payments.  This practice is so widespread that I will hypothesize that customer borrowing is already the most significant source of financing for SaaS and cloud businesses.

This type of borrowing has tax advantages.  You get the money this year, but you don't record it as income.  Instead, you record it as deferred revenue, which is a liability that you don't pay taxes on until you fulfill it.  Your business could grow a long time, with positive cash flow every year, before you get to the point where you fulfill enough of this revenue to owe taxes on it.

So far, borrowing sounds great.  But, it is expensive.  The 20% discount gets applied over only a few months.  So, the effective interest rate earned by customers that pay in advance is more than 40% per year.  Typical discounts range from 17% (the commmon practice of selling an annual subscription for 10x the monthly price) to 50% (for example, Amazon's "Reserved" pricing).  Can we borrow more cheaply from a bank?

High profit potential of lending to SaaS companies

Lenders clearly have a lot of pricing power, if the alternative is to pay from 17% to 50% interest.  The margins in a lending business could be great.

I placed a call to my friendly neighborhood representative of Silicon Valley Bank.  He said that SVB is "thinking about" a program for lending against subscription revenue that is similar to a receivables lending program.  The bank would advance a certain percentage of revenues - say 4 months of revenues from the most reliable customers - and then collect this money directly as the customers pay.  The cost for this would be 19%, with a $500K minimum.

My jaw dropped when I heard about the 19%.  Typical interest margins in business lending are 4-5%.  In this case, the bank is borrowing from the fed or from depositors at about 1%, and lending it out at 19%, for an 18% spread.  This is four times the normal spread, and it comes to a lot of money.  If you take 18% times the $500K minimum, you realize that these guys won't return your call for less than a $90K payoff.

However, they can probably get something close to the 19% because the alternatives are at least as expensive.  So, through a combination of huge subsidies on the funding side, and jacked up rates, these guys are making four times the normal price for their product.  I don't know about you, but if someone came to me and offered me four times the normal price for my product, I would scramble to sell as much of it as possible. They aren't doing that.

How to we scramble to sell this product?  What's required to make this business work?  I think two things.  First, a simple credit rating formula.  Second, a way to hold collateral.

I think the first thing that is required is a credit rating formula for SaaS companies that shows how much lending the business can support.  Bankers love simple credit rating formulas, because if everyone agrees on a formula, they can get other bankers to chip in money.  These formulas can have far reaching effects.  They are the foundation for hundreds of billions of dollars in mortgage lending, credit card lending, private equity lending, etc.

Interestingly, these formulas are often wrong.  Michael Milkin made billions when he realized that the formulas used to calculate losses on junk bonds were actually too pessimistic.  More recently, the formulas for calculating AAA ratings on mortgage securities were spectacularly wrong, and too optimistic.  They turned out to be based on the assumption that housing prices would never fall.  This assumption was both historically wrong, and not supported by common sense, given that housing prices were at historic highs.  However, as long as all the bankers agreed to suspend their disbelief at the same time, they could buy each other's deals, and the system worked.  I digress.

In this case, we will be lending our own money, so we should make a good formula.  That doesn't mean it will be complicated.  It would take into account the average duration of a subscription, the growth rate of subscriptions, fixed costs, and variable costs, and it would estimate the sustainable rate of borrowing.

The second thing that we need is collateral.  Even when ability to pay is good, lenders will want collateral.  And, collateral will reduce the interest rate.  Historically, software has not been acceptable as collateral.  However, progress never ceases.  Through the magic of virtual servers, we CAN get acceptable collateral from a SaaS company.  We can get images of their code, operational servers, and databases.  Then, in a worst case scenario, it's easy to seize the servicing operation and run it.  It could actually be faster to transfer this type of collateral, and cheaper to run it or sell it, than hard assets.

So, with this plan, SaaS lending is needed, profitable, and safe.  Who is going to do it?  If you are offering this type of service, or interested in working on it, please contact me.