Financing Options for SaaS startups
One could argue that there hasn’t been a better time in the UK to raise financing. We are seeing unprecedented levels of capital going into private innovation businesses from VC to PE funds, angels to corporates, and even some of the larger hedge funds throwing their hats in the ring. One source of capital that is also on the rise is debt financing. While many fast growth VC-backed businesses in the US have been raising debt financing alongside equity rounds for decades, the knowledge, utilisation and comfort levels among UK businesses varies greatly from their counterparts on the other side of the pond.
It is incumbent upon entrepreneurs to find financing that supports rapid growth and expansion plans. In an environment with an increasing variety of choice, it is important for entrepreneurs to make savvy decisions that leave the business with options for the future and in a position of strength. One must consider not only the overall cost of capital but also the most efficient blend of debt and equity, scalability and suitability of capital depending on the maturity of the company. The good news is there are now more choices for UK businesses in terms of the type and source of debt financing. Local banks are waking up to the fact that innovation is critical to our ecosystem and are becoming increasingly open to lending to tech businesses, there are a number of existing and new venture debt funds ready to write a cheque, and US competitors are giving both local banks and funds a run for their money.
From a debt financing point of view, there are a number of non-dilutive and less-dilutive financing options specifically for SaaS businesses. They include venture debt or growth capital, recurring revenue lines of credit, standard working capital (trade debtor or invoice discounting) or revolving products and mezzanine or junior finance. The below will cover venture debt or growth capital in detail, with following articles diving into other debt products with the same level of detail.
Deep dive on Venture Debt
Venture debt can be a powerful financing tool to serve a variety of purposes. Many founders look at taking venture debt to:
- Extend cash runway to the next equity round
- Invest in product development, customer acquisition channels or people to a greater extent than an equity-only round will allow
- Act as an insurance policy – things always take longer than we think
- Pursue new geographic expansion
- Progress new product testing
- Allow for capital expenditure or hardware purchases
- Complete acquisitions
- Build a bridge to profitability
The key is to use debt wisely, giving a business additional firepower to help achieve milestones, hopefully resulting in an increased valuation at the next equity round and thus reducing ownership dilution – effectively helping an entrepreneur to do even more with their expensive equity capital. It is, of course, a debt solution and as such must be repaid; however, it comes at a fraction of the cost of equity and in most cases is used as a supplement to an equity round rather than as a replacement.
Below is a summary of key venture debt terms and what to expect in the market:
- Type of Facility: Senior, amortising term debt.
- Amount: Typically venture debt is used to supplement an equity round, not to replace it. As a rule of thumb, a venture debt lender will aim to provide 30% to 50% of an equity round.
- For example if you raise a £5M Series A, many lenders will look to provide £1.5M to £2.5M. Having said that, we have seen the equity to debt ratio weigh heavier towards debt in later rounds when a lender can see increased evidence of enterprise value, revenue traction or when a business is nearing profitability.
- Tranching, or staged draws, of debt is sometimes included. Tranching may be time based or tied to performance metrics (MRR for example).
- Repayment: Typically amortises over 3-4 years with repayments due on a monthly or quarterly basis.
- The critical factor for a company is to ensure the debt extends runway. As such, it is common to see a 6 to 12 month draw period (meaning that funds are available to the business, but have not yet been drawn) or interest only period (funds are drawn, but principal repayment has not yet started so you are just responsible for interest payments) negotiated into a deal. If you are unsure of what runway the debt will provide, the lender should model this out for you in your projections.
- Cost: A lender’s compensation will usually consist of a few key components – upfront fee (between 0.5% to 2%), back-end fee or final payment (between 0 to 4%), interest rate (7% to 12%), early pre-payment fees and warrant coverage (7% to 12% of loan amount).
- Prepayment Fees: In today’s market this ranges widely. The lender’s terms may require you to pay all future interest or indeed no fees at all towards the end of a facility. Things change quickly in an early stage business so understanding how penalised you will be if you repay early is important.
- In addition, it is market standard for the company to pay for the lender’s legal fees as well as their own legal fees, so efficient negotiations help all sides. It is also helpful to find a lawyer that has negotiated these types of deals before.
- Due Diligence: This should be done internally by the lender. Unless you are looking at leveraged buyouts or some types of mezzanine products, the vast majority of senior lenders should piggy back off equity due diligence and company-prepared information. A company should not incur additional external costs when taking on this type of debt.
- Covenants: Venture debt does not have financial covenants. If you are offered covenanted debt, this is a senior debt product and should be priced accordingly (i.e. less expensive!). One of the main benefits of venture debt is the level of flexibility, which would be restricted if the business were being tracked with financial covenants.
- Collateral: The vast majority of Lenders will take a full mortgage debenture on all assets of the business, including IP (i.e. fixed and floating charge).
- Board Seat or Board Observer Seat: Not applicable and should not be included.
- Information Sharing: Most lenders want and expect full transparency. As such you must provide monthly information, board packs, audited accounts, as well as regular in person updates.
At its heart, venture debt or growth capital is a very simple product. It is essentially term debt that should result in 6 to 12 months of additional cash runway. Given the flexible nature of the debt, it is usually one of the more expensive leverage options. If you’re looking for a cheaper financing solution or are a growth stage business, look into a recurring revenue line of credit or an accounts receivable line of credit. These facilities are often used in conjunction with a venture debt facility and are not only less expensive, but also help to ease the burden of debt service when your principal repayments kick in, as they scale with the business. I will cover these in more detail next month.
Key tips if you are thinking about taking Venture Debt
Now that we’ve covered the main uses and components of venture debt, here are some important tips that should help set you up for the future:
- If you take debt from a fund as opposed to a bank, ask for a carve-out for working capital products. This allows you to access less expensive and more scalable debt down the road. It is also helpful to set these expectations up front as opposed to trying to renegotiate after you have committed, as in most standard loan agreements additional debt is tied to consent from existing lenders.
- Sometimes there really is too much of a good thing. We encourage our entrepreneurs to be thoughtful and prudent, particularly at the earlier stages, with the amount of debt they bring into the business. Venture debt will need to be repaid and when those debt service payments kick in it can really hamper reaching cash flow breakeven or attracting a new lead investor – this is because they don’t want their equity going towards repaying debt.
- Do as much due diligence on the source of capital as they do on you. Whether its debt or equity, you are entering into a financial contract. There are a number of banks and funds that have consistently supported businesses through rough times and down turns. Find those partners, as you want a patient and an experienced lender on your side to help navigate the bumps in the road.
Post produced in partnership with Erin Platts Managing Director, Commercial Banking, at Silicon Valley Bank.