As we approach the end of 2019, everyone’s suddenly focused on gross margins and startups that can (gasp!) generate profits. It’s a welcome change of pace from the burn at all costs mentality of the last 5+ years. But this isn’t the only trend. In some weird twist of fate, venture debt (in all its forms) has become the topic du jour and — dare I say — popular?
It’s a weird feeling seeing and hearing many more people talking about debt and about the appropriate uses of debt capital for fast growing companies. About ten years ago I wrote a few blog posts highlighting the basics of venture debt simply because I couldn’t find anyone else who had shared the information online. I talk to high growth companies everyday who are trying to figure out how to use debt appropriately and thought it would make sense to write a few update posts breaking down the market and things to focus on when assessing this question.
Why Venture Debt?
While venture debt can be used for runway extension or general growth purposes in almost any type of company, my specific focus will be on enterprise SaaS models and other recurring based revenue models. This is where we are seeing the most disruption in terms of new lending models and sophistication around how operators and equity investors are thinking about using leverage.
The 2018 KeyBanc SaaS Survey indicated that by the time companies get north of $5MM in ARR, more than 75% are using debt capital (slide 63). This is good news for venture bankers like me — but also has led to a surge of new entrants into the market including revenue based lenders, non-bank lenders, and new banks entering the venture space (guilty as charged!)
Entrepreneurs are becoming more sophisticated in their understanding of how to grow a SaaS business and the underlying dynamics of the industry make debt a tempting option. SaaS businesses are inherently math exercises — what is my cost for acquiring a customer (CAC), how much margin can I generate off that customer (Gross Margin), and how long can I keep customers (LTV). Most high growth SaaS businesses have negative cash flows until reaching significant scale (and often even then, voluntarily, if the math works). This is driven by the fact that enterprise value is driven by a multiple or revenue — or more specifically, by a multiple of annualized recurring revenue, which is the expected revenue in the future.
You can see how this can all snowball pretty quickly –the 10/31 SaaS Capital Index of public SaaS companies has an EV/ARR multiple of 8.8x and we’re seeing private company valuations in the 6–8x range regularly for growth rounds and north of 10x ARR for the fastest growing venture stage companies. If you have a company that is growing at 50%+ year over year and commands an 8x valuation, the result of extending runway by even 6 months is 25% less dilution. The impacts gets even more wacky (and awesome for existing shareholders) when you have fun with math by juicing either the growth rate or multiple. In short, the (relatively) low cost of debt accessible by SaaS businesses makes it worth considering as part of the capital stack.
The Market Today
Within the venture debt market, there are a variety of different options available depending on the stage of revenue and prior equity capital that has been raised, with some overlap between the different options.
Venture Banks: the biggest piece of the overall SaaS lending landscape. Most of the venture banks will require an institutional equity investor prior to getting involved on the debt side. In certain instances (with enough scale or enough visibility to a round in the future), the banks will sometimes provide financing prior to an institutional round. In these cases, they are likely to tranche in the availability and/or put in triggers to ensure a round comes together.
One advantage of bank debt is that it’s the cheapest of all the options — banks typically require a full relationship with their loan clients which provides deposits which provide a low cost source of capital. In addition, banks can scale with SaaS businesses as they grow, putting in place facilities that are tied to MRR — I’ve been a part of deals that started as $1.5MM MRR lines and grew to more than $25MM commitments in a few years.
Banks take a senior lien and the deals may include covenants — at a minimum they will require monthly reporting and other basic restrictions on certain activities that require lender consent.
The bank landscape has long with dominated by Silicon Valley Bank, who effectively created the venture banking model and has the biggest market share. But the market has seen a lot of transition in the last couple years and now more than ever there are opportunities to get market terms from a couple different players. Other active players include: Bridge, CIBC, Comerica, Live Oak, PacWest , Stifel and Signature (full disclosure, this is the group I helped launch in q1 2019…so, they’re great) :)
Debt Funds: there are a variety of non-bank lenders who have dedicated pools of capital which they invest in debt instruments into high growth, VC-backed companies. The overall cost of capital for debt funds is more expensive than bank debt, but also comes with less structural strings attached (i.e. typically no financial covenants). Most of the debt funds will require an institutional equity investor and often the debt is structured with a forced draw down and then a repayment schedule over several years. Some companies that are scaled beyond $10MM in ARR will begin to think about fund debt (sometimes called “mezz debt”, “subdebt” or “junior debt”) when they are operating with nice growth rates but without a ton of balance sheet liquidity. If existing investors are tired or out of dry powder — or if an exit seems to be on the horizon over the next 2 years — companies can sometimes look at putting in junior debt to provide cushion to the outcome. It is often subordinated to senior lines, resulting in a blended cost of capital and availability that makes sense for the near term needs.
While not an exhaustive list, existing players who I’ve seen play in the SaaS space include: Eastward, Escalate, Espresso, Hercules, Horizon, Level Structured Capital, Multiplier, North Atlantic, Orix, SaaS Capital, Trinity, Triple Point, & Vistara
Revenue Lenders: as noted earlier, there is a new crop of venture lenders who have emerged with innovative models for earlier stage companies. Many of these players are employing “royalty” based approaches or have repayment that is tied directly to revenue. They will advance an amount up front (typically 4–6x MRR but potentially more) which the company can use for operating and growth activities — this capital acts as a substitute for raising equity capital, with the advantage of being non-dilutive to the cap table. Repayment typically begins immediately, with a % of monthly cash receipts applied directly as payments until a pre-negotiated repayment cap is met. This repayment cap is usually ~1.2x — 2x the original advance amount. The effective cost of capital is dependent on how fast the company grows — if revenue takes off and/or the company raises a round of capital and repays the debt in the first couple years, the IRR for the lender can be north of 20%. If it takes 5 years to repay, the rates are closer to 10%. The revenue lenders are sometimes investing small amounts of equity as well and there is a high degree of variability across the various lenders in terms of flexibility on terms. Almost all will come into companies earlier than any of the other parties in the venture debt landscape, making it an attractive option to look into for many companies in the $2-$4MM ARR range who are capital efficient.
Summary / Look Ahead
The predictability of revenue and the relative capital efficiency of companies means that the debt discussion has started to happen earlier in a company’s lifecycle. It’s common today to see companies get to $1–3MM in ARR on seed and/or friends and family rounds. It’s possible to get access to cheap capital that is non-dilutive as your company scales. The math works, so debt is a great solution, right?
The answer, of course, is nuanced — it’s a great big maybe.
Within each of the different options there are pros and cons and we’ll get into some of the specifics in future posts to provide a holistic view on how to approach the prospect of raising venture debt. If you have specific questions, please reach out and I’m happy to serve as a resource for you.