At SaaS Capital, we firmly believe the use of debt to finance a growing SaaS business is savvy and financially rewarding for the founders and early investors. In fact, we can site numerous cases studies that demonstrate a 3x, 7x, and up to a 91x, return on investment from the use of our debt facilities vs. equity financing. And, although it is relatively early in our collective experience, (7 years), none of our borrowers has failed to repay our loans, or destroyed value by over-levering their company.
All that said, leverage is a wonderful thing when things go well, but investors and entrepreneurs should think about the difference between equity and debt if things do not go well. You might think this is an unusual thing for us to write about, but the fact is, the more educated our prospective borrowers are, the better it is for everyone, and everyone should understand the benefits as well as risks of leverage.
The key differences between equity and debt
Biggest benefit of leverage: as described above, financing growth without reducing ownership can have a large impact on returns to shareholders. SaaS Capital has routinely financed SaaS businesses that have increased their equity value by $10 or $20 million or more while paying less than $1 million or $2 million in interest and fees and selling only 1% or 2% of the business in the form of warrants. Financing that same growth with equity would have cost the owners 3 to 7 times more. (See our case study for one example.)
Biggest downside of leverage: Debt needs to be repaid when it is due. Seems straightforward, but it is the biggest difference between equity and debt. Both equity and debt may rank senior in repayment to existing shareholders, but it’s debt that has a fixed repayment schedule that is not tied to a liquidity event. It is this feature that reduces risk for the lender, and therefore reduces cost to the borrower.
The key financial implication is, in the absence of more financing, as a levered SaaS company reaches the repayment period, it has less money to invest in the company because some of its cash is going to service the debt. If the SaaS business is growing, and the financial markets are functional, most SaaS businesses will not find themselves ever facing this issue. Our portfolio companies are in high demand by private equity firms and acquirers at the moment, and for those who have desired, we have renewed and expanded their facilities. That said, can anyone remember way back to 2008, when money stopped flowing?
It is important for planning purposes to understand the implications on the business if no new capital is available. Can the business service the debt, and if so, what are the tradeoffs in growth that will need to be made? Will the business need to go into hibernation mode, or will it still be able to invest in some (although fewer) initiatives? What percent of the workforce might need to be let go, and at what point might that cause other destabilizing exits?
At SaaS Capital, we focus our underwriting and loan structures in a way that our borrowers can “comfortably” repay the debt over time with their own cash flows. Comfortably, however, is a relative term, and it does mean that some growth initiatives will go un-funded, and growth will to some degree be sacrificed for cash-flow.
Our facilities have a gradual and well defined ramp-up period, and a gradual ramp-down period. The latter is crucial for the borrower. Annually renewing bank lines with no defined amortization structure are great, until they don’t renew at which point everything is due, and the borrower is at the mercy of the lender to work out a payment plan.
The big take-away we are trying to describe here is that leverage can be used very rationally, and if carefully constructed, can have modest downside implications even in a period of financial disruption like 2008, and in a more favorable environment, create significantly more value for shareholders. The right amount, and in the right structure, are the two critical components.
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