When It Comes to Funding, Not All Options Are the Same
Recently, we did a side-by-side comparison of equity vs. debt capital funding for growing SaaS companies. Both are outstanding options for organizations that have grown beyond the seed and early stages and are generating strong, stable, and sticky monthly recurring revenue (MRR).
However, it can be easy to lose sight of both the short- and long-term outcomes and costs of these options. It can also be easy to let the risks outweigh the benefits of each platform, despite the potential for the benefit to be greater. One particular area of concern is the cost of capital for startups using one of these two options.
Take venture debt financing for example. At its core, debt financing is exactly what it sounds like: a business loan. In exchange for the principal loan amount, borrowers must also pay interest. While it may seem counterintuitive to go into debt in order to grow a business, the long-term benefit of doing so could outweigh the long-term result of equity financing (see our recent comparison as an example of what two founders who took debt and equity respectively received upon the sale of their businesses after four years).
That’s because the interest component of the loan repayment still doesn’t add up to be as high as the amount of money the equity investor would take upon the sale of the company down the road. While principal and interest payments must still be made on a monthly basis, the long-term advantage is clear. If a company has good cash flow, principal and interest payments during the growth period prior to sale wouldn’t be a problem. And strategically, it produces a more favorable outcome when the owner does decide to sell.
This long-term result should also be a consideration for companies considering equity financing. While there is no monthly payment to be made with equity, the cost comes down the road when the owner decides to sell. The equity partner must be reimbursed based on the amount of equity they own in the company. And depending on the amount of equity that the investor holds, the remaining proceeds for the company owner could look very different than if venture debt had been utilized.
What You Decide Comes Down to What You’re Comfortable With
Both equity and debt have their advantages when it comes to the cost of capital for startups. But there are more factors that must be considered as well because they impact the daily operation of the business.
On the equity side, your investor will likely occupy a board seat — making them a part of your company’s operations and decision-making. They will be involved in important hires, financial decisions, and other directional discussions about the future of the company. Their opinions and decisions must be combined with those of other SaaS business leaders and owners. This is because they now have a vested interest in the performance of your company and want to be part of the choices made on its direction and what the resulting financial impact will be.
However, SaaS equity financing also comes with a number of benefits. Again, no monthly payment needs to be made. The investor will be involved until the company decides to sell or otherwise buys back the equity given to the investor. And in the event that the company fails, the equity may not have to be paid back.
Equity financing also opens the door to the investor’s connections, which can prove useful as the company grows, seeks new business and partnerships, and so on. And because equity investors are part of the company’s leadership through their investment, owners and other leaders gain access to their expertise and insights. They’ve likely invested in a number of other companies similar to yours and understand what has worked and what hasn’t.
On the debt side, companies still have access to their lender’s expertise and guidance, but the onus is on the company owners and leaders to make something of their investment. The principal and interest will still be due, whether monthly or revenue-based. Another consideration with debt lending is the loan mechanisms built into the arrangement. These include warrants and covenants.
Warrants are mechanisms designed to incentivize lenders to provide funding in exchange for the option to buy stock at a predetermined rate. The lender must exercise the warrant ahead of a predetermined date as well. While these can help sweeten the deal for a lender, they also mean that the lender now has the ability to own a portion of your company, if they so choose. Unlike other venture debt lenders, River SaaS Capital does not take warrants in exchange for funding.
A covenant is another loan mechanism that sets financial and performance requirements as part of the agreement. They are designed to reduce risk to the lender and keep the borrower at a certain level of performance. For example, SaaS companies that take on debt with a covenant might be required to maintain a certain number of new subscribers or monthly recurring revenue while also keeping burn and churn rates low. These metrics might be evaluated on a monthly or quarterly basis. If a covenant is broken (called “tripping”), the lender has the right to re-evaluate the relationship or impose some restrictions on future lending.
Learn More About the Cost of Capital for Startups
At River SaaS Capital, we value our partnership with our clients and our ability to work closely with them to achieve their goals. We believe in their businesses and want to see them succeed. If you want to learn more about the options presented here and their impact on the cost of capital for startups, fill out the form below to have a conversation with our investment team.