For most businesses looking for funding, there are generally two broad options available: debt or equity.
Businesses in the UK tend to be averse to borrowing and, as traditional debt hasn’t typically been an option for fast-growth (or loss making) SaaS businesses, most choose the ‘sexier’ equity option and fundraise.
However, given the rapid growth of revenue-based financing (RBF) and current VC market conditions, it’s a good time to rethink those options. RBF lenders have seen a steady rise since 2005, with 32 US firms managing around 57 funds representing an estimated $4.3bn in capital, according to a TechCrunch report from last year.
In a recent article, it has been said that 85% of SMEs in the UK are unaware of revenue-based financing and as SMEs comprise 99% of all UK businesses, it could be a viable option that many are potentially missing out on (European Business Magazine, Sept 2022).
Founders are seeing the advantages of RBF which can offer quick turnaround in securing new funding and in some instances, being done within days. It’s often easier for SaaS business to secure this type of funding given the relatively predictable nature of their recurring revenues. This type of funding can enable you to capitalise on opportunities for your business quickly, by offering an instant influx of capital and more immediate growth.
Understanding whether RBF is right for your business is key though. “Despite the benefits, a business cash advance may not be the right funding option for all companies. One major drawback is that businesses need large gross margins for the revenue-based finance to work. Stable monthly revenue is also essential; the loan terms are entirely based on future revenue, so a predictable monthly income can ensure favourable terms.” (The Ultimate Guide to Revenue Based Financing, Fundsquire, July 2022).
We’ll look at the differences between the two options and the true costs to founders, helping you make a better-informed decision when it comes to funding your growth.
Debt financing for SaaS businesses
Debt is debt, meaning it needs to be repaid at some point. However, unlike equity funding, you’re not inviting others into your cap table or Board room so when the debt (and interest) is paid back, your liability, and relationship with them, is over. In recent years, we’ve seen a meteoric rise in the availability of revenue-based financing for SaaS businesses through lenders such as Outfund, Uncapped, Pipe, Wayflyer or marketplaces such as Capitalise.
Many of the advantages and disadvantages of equity funding are flipped for debt funding.
Equity funding for SaaS businesses
While equity funding is a great option (angel funding or venture capital) for fast-growth businesses, it can be distracting for founders as it takes a lot of time to pull together the right information, find the right investors and negotiate a term sheet. However, the straight cash injection without short or medium-term repayments is attractive, and so is the additional support mechanism. However, you will lose some control and equity of your business in the process.
Advantages and disadvantages of equity financing
- Investors bring a wealth of experience to help your business grow.
- Equity investors tend not to rely on credit scores to make investment decisions.
- You won’t need to repay the funding (in the short-term) which helps with cashflow.
- It’s relatively risk-free (save for reps and warrants).
- The investor group will have partial ownership of your business, it could dilute your control, ownership and speed of decision-making.
- Any dilution will impact your exit value.
- The process of equity funding can be time-consuming and distracting from growth.
What is revenue-based financing?
Based on your annual growth rate, gross margin, churn, diverse customer base, net revenue retention (NRR) and a strong enough runway, revenue-based financing is funding from lenders who take a proportion of ongoing recurring revenue from the business until the original loan (and interest) has been repaid.
Example repayment structure which fluctuates with revenue (source: Uncapped)
Key assumptions (source: Uncapped)
How revenue-based financing works
In order to secure this type of funding, a business needs to have a strong holistic picture across the following areas to be successful:
- annual growth rate that indicates a growing business
- good SaaS businesses tend to have a better gross margin
- a diverse customer base which isn’t reliant on one or two large customers
- the ability to upgrade contracts through existing clients through net revenue retention (NRR), and
- a strong enough runway to help a lender feel comfortable, preferably more than nine months.
The great thing about this type of financing is that it’s intrinsically linked to regular revenue, and therefore, it's scalable.
As revenue grows, you can either become more self-sufficient in your business, or continue to accelerate growth by renewing the RBF facility but based on your new higher revenue numbers.
Advantages and disadvantages of revenue-based financing
- It’s affordable as it’s based on your monthly revenue.
- Despite the apparently high APR, it’s typically more cost effective than giving away equity.
- Once the debt has been repaid there doesn’t need to be any further relationship.
- Lenders don’t have control or influence over the company, so you can maintain ownership and direction.
- The amount you’re able to borrow through revenue-based financing is generally lower than through equity funding (typically 6x MRR).
- Revenue-based financing is repayable, which adversely affects monthly cashflow, whereas equity funding isn’t.
- It’s a relatively short-term debt instrument which can impact confidence in medium and long-term planning.
- There is greater risk attached to debt.
Is revenue-based financing cheaper than equity?
Most people in the UK are predisposed to not borrow from a business perspective. While it looks expensive, it could well be a lot cheaper in the long run than equity.
Example revenue-based financing v equity funding:
Ownership impact of £1m revenue-based financing v equity funding
Key assumptions (source: Uncapped)
For the purposes of this example, we’ve excluded:
- Deal costs e.g. legal and other professional fees.
- Management time costs.
Top tips for getting funding in the next 12 months
As equity funding is tightening up, revenue-based financing will become even more attractive to SaaS businesses looking to grow. Here are some top tips if you’re considering revenue-based financing.
1. Take on debt carefully
As with any financing, you need to do your homework before taking on any debt. Justin Langen from Uncapped explains it this way, “The market for revenue-based financing is still very new and constantly evolving. At this point in time the rates available to businesses are increasingly attractive. From an Uncapped perspective, it’s cheaper than it’s ever been to secure a debt line. However, you have to understand what you can afford, like any consumer would. It is important to take into account potential future cashflow restraints that may affect the business later down the line. In turn, it is the role of the responsible lender to only ever offer you debt that is clearly serviceable by your business’ current metrics.”
2. Have a longer runway for debt financing
Justin goes on to say, “I would encourage businesses to approach debt with long term planning in mind from the outset. If you’re approaching a lender with three months of runway remaining in search of a 12-month loan, it is unlikely you are going to achieve your desired outcome. Taking on debt should be approached proactively rather than reactively, it’s not a last resort or emergency capital. If a company with 12 months of runway and a company with three months of runway compared their offers from lenders, the difference would clearly illustrate the value of retaining a healthy cash reserve. This is true for the rate, term and amount. Being proactive and forward-planning for debt gives the lender confidence that they will be paid back. The more hard data you can show them to prove that they will recoup their investment, the more likely you are to get to the amount, price and term that you are hoping for.“
3. Have clear visibility and metrics on the acquisition side
In order to get the funding you need, you must understand everything about your business. Be able demonstrate your net revenue retention (NRR), customer retention, a strong runway and other aspects to investors be clear on the status of your business.
4. Understand your metrics
flinder CEO, Alastair Barlow reiterated the importance of knowing your metrics and understanding how much funding you need and can afford. Key SaaS metrics such as MRR, gross margin, cash burn and growth rate are fundamental to understanding what you can afford. Knowing historic performance and modelling this out in a realistic cashflow forecast is important to understand both how much you can afford and how much it will help you grow.
As mentioned in previous articles, there are a number of metrics you should know if you're raising investment which apply equally to understanding how much debt you should be raising.
Whatever funding option you choose, be sure to research it thoroughly before applying. And remember that raising capital for your start-up comes with risks. Carefully consider taking either on carefully and understand the impact on your business today, and in the future.