Recurring revenue, unique financial metrics, tailored funding: SaaS financing works with different criteria than traditional corporate funding. What do SaaS companies and startups need to pay attention to when considering finance?
What is SaaS financing?
SaaS financing, SaaS finance, or SaaS funding refers to the process of raising capital to develop, grow, and scale a Software-as-a-Service business. It is a specific financing option for companies that offer SaaS or a subscription-based business model. This capital is typically used for product development, marketing, sales, and hiring.
Many SaaS companies generate revenue from recurring revenue. The revenues typically occur in Annual Recurring Revenue (ARR) or Monthly Recurring Revenue (MRR). If a SaaS company wants to increase its revenue, the customer base must grow – and a SaaS business needs adequate capital to do so.
Based on these regular and predictable revenue streams, SaaS companies access financing models that are tailored to their needs.
Why is SaaS finance special?
SaaS financing is distinctive due to several factors:
- Recurring revenue model: SaaS companies operate on a subscription-based model, where customers pay regular fees for ongoing access to the software. This predictable revenue stream is attractive to investors because it provides greater visibility into future cash flows.
- Scalability and growth potential: SaaS companies often have the potential for rapid scalability without a proportional increase in costs. As more customers subscribe to the service, revenue can grow exponentially without significant additional expenses.
- Technology and innovation: SaaS companies operate in a dynamic market where technology and innovation play a critical role. Investors evaluating SaaS companies consider factors such as software quality, differentiation from competitors, and strength of intellectual property.
- Metrics and KPIs: SaaS financing often revolves around specific metrics unique to the industry.
- Exit opportunities: SaaS companies may have different exit opportunities compared to other types of businesses. Potential exit strategies for SaaS companies include acquisition by larger tech firms, IPOs, or mergers with other companies.
Types of SaaS financing
SaaS financing offers a variety of funding models to companies with recurring revenue. As with any other financial instrument, founders should consider what they need the capital for and in what period. It depends on the investment if debt or equity capital is more suitable.
Here are three ways of SaaS finance via equity.
SaaS equity financing
Bootstrapping
Bootstrapping involves funding a SaaS startup using personal savings or funding from friends and family. While bootstrapping allows founders to retain full control over their company and equity, it may limit growth potential due to constrained resources.
Venture Capital
Venture capital is a popular type of financing for SaaS startups. Founders sell shares and receive equity in return. Venture capital is popular with many SaaS companies in phases when they need a lot of capital. However, it also comes with equity dilution, which means loss of control and co-determination rights.
Business Angels
Business angels are relevant in the early phase of a SaaS company. They act as investors and provide networks and know-how in building and scaling a company. In many startup fundings – SaaS-related or not – business angels play a crucial role in the early stages.
SaaS debt financing
However, financing a SaaS company is not only based on equity. SaaS debt financing also plays an important role.
Venture Debt
Venture debt describes raising a risk loan shortly after or at the same time as venture capital financing. A startup accesses debt financing to remain liquid between two equity rounds. It can be appealing to SaaS startups emerging from the early stages. They have to sell fewer company shares in return for fresh capital. Venture debt, however, can come with a high cost of capital, personal collateral, and warrants.
Alternative Debt Funding
In recent years, various alternative financing models have become established, aiming at SaaS companies and providing debt capital. These include instruments such as revenue-based financing or recurring revenue financing for SaaS. They focus on the recurring revenues of a company.
These solutions are typically non-dilutive and do not include personal guarantees or warrants. They can be tailored to the exact capital needs of SaaS companies, offer customized repayments, and are designed long-term. SaaS startups raise exactly the amount of capital they need and can flexibly expand their funding. re:cap also offers such an alternative financing model based on debt capital.
SaaS company phases and their financing needs
A SaaS startup progresses through various business and funding phases. It has specific capital needs and needs to make investment decisions at each stage. Phases two and three, in particular, can be capital-intensive.
Phase 1
The company's software product is not yet live. A startup focuses on the product development and initial testing of a beta version which will be available to selected users.
In this phase of SaaS financing, the founders' capital, business angels, or investments from friends and family are at the table.
Phase 2
The market launch of the product is imminent. The aim is to make the software accessible to a larger market and to develop it further, adding new features or expanding existing functions.
Through sales activities, the SaaS startup gains its first customers and builds its customer base. It also receives initial feedback from a larger audience about its product offering – the search for product-market fit begins.
The second phase is the first capital-intensive of a SaaS startup. A larger SaaS financing becomes relevant. Depending on the case, the company may open to venture capital investors or business angels and raise VC funding.
Phase 3
The SaaS startup has already acquired a significant number of customers, and product market fit has been achieved, at least temporarily. Now, the focus is on driving further growth based on the existing customer base and scaling the SaaS business model. Efficiency is in the spotlight.
It's time to scale the business model and turn the startup into a scaleup. Usually, fresh capital is needed to do so. In this phase, debt may become relevant for the first time, in addition to the traditional options for raising equity. Because the company generates predictable and recurring revenues, it becomes more attractive to debt investors.
Phase 4
The SaaS startup has been successful in the market for several years. It has achieved stable revenues and has established itself against its competitors. In this phase, further growth initiatives such as acquiring competitors, new markets, and further professionalization of the company structures are on the agenda.
A SaaS company can diversify its capital structure: both equity and debt financing might be useful – depending on the company's goals and needs.
Company phase determines SaaS financing instruments
Whether it is equity or debt: there is a suitable financing model for every company phase and every investment. In the meantime, founders have a wide range of options that can precisely serve their capital needs.
The various phases of a SaaS company are characterized by growth, scaling, and the further development of the product offering. Founders make decisions, especially in phases two and three, that have long-term effects on growth and the company.
SaaS finance decisions should be carefully considered in advance. Depending on the type of SaaS financing, the company's shares may be heavily diluted. In the current environment, the cost of capital also plays an essential role.
Metrics and KPIs relevant in SaaS financing
Before investors decide for or against a SaaS startup, they look at specific SaaS finance metrics. These KPIs typically only exist for companies with recurring revenue. They include:
- MRR or ARR
- Customer Acquisition Costs (CAC)
- Churn Rates
- Profit Margins
- Customer Lifetime Value (CLTV)
- Rule of 40
Challenges of SaaS financing
The SaaS market has experienced significant growth in recent years. This has been accompanied by many startups as well as the development of new business models (platform economy). This has now led to challenges in SaaS funding. These include:
- Market saturation: the SaaS market is highly competitive, with numerous players vying for market share. Securing funding in a crowded market can be challenging, especially for early-stage startups without a unique value proposition.
- Churn and Customer Acquisition Costs: high customer churn rates and escalating customer acquisition costs can deter investors and strain cash flow. SaaS companies must demonstrate effective strategies for reducing churn and acquiring customers cost-effectively.
- Valuation pressures: balancing the need for capital with maintaining reasonable valuations can be tricky. Overvaluing or undervaluing a SaaS company can impact fundraising negotiations and long-term growth prospects.
- Technological changes: the SaaS industry is characterized by rapid technological advancements and evolving customer preferences. SaaS companies must adapt quickly to remain competitive, which may require continuous funding efforts.
Conclusion: financing SaaS is a different ball game
As for all startups, funding is essential for young companies with a SaaS business model. Yet the SaaS market is highly competitive and continuously growing. From 2012 to 2022, global SaaS revenue increased by more than 900%. The business models of many startups are now focused on SaaS or include corresponding subscription-based components.
By understanding the various types of funding, implementing effective fundraising strategies, and navigating the challenges of the SaaS market, founders can secure the capital needed to scale their businesses.
However, financing a SaaS company works according to different rules. Investors and founders use metrics and KPIs as a basis for their decisions, which play a subordinate role in conventional business models. Due to the comparatively good predictability of revenues, tailored funding is possible. It matches precisely the capital needs of companies.
