SaaS finance - funding for SaaS companies

A SaaS company (Software as a Service) is a company that provides software applications/services to customers over the internet. Instead of purchasing and installing software on their own computers, customers can access the software through a web browser or mobile app. The SaaS company typically charges a subscription fee for the software and the associated services (e.g., technical support, updates).

SaaS financing is available to tech-enabled businesses that have an online proposition and receive subscription or contracted payments for services. If your business doesn’t quite match this, but you receive card payments you may be eligible for a merchant cash advance, which is a slightly different solution. Register with Swoop to speak to one of our Funding Managers to discuss your options.

SaaS stands for ‘Software as a Service’. It refers to technology companies that maintain computer servers to host proprietary software applications in the ‘cloud’. Customers access these applications via the internet.

SaaS customers do not buy these applications outright. They rent them. Usually paying a monthly subscription fee to use the application. Some subscriptions are a flat fee, others may be based on how much data can be stored, or the number of users who may access the applications, or the level of service desired.

SaaS companies differ from most other businesses because they do not sell a product that the customer may own or offer a service that fulfils a single task. SaaS organisations create software solutions to a problem or need and then rent the software to users on a rolling basis. SaaS companies typically refer to their customers as ‘members’.

The core worth of SaaS organisations is set in the effectiveness of their applications, the number of members they have, and the value of future membership fees. Because many SaaS companies experience a high ‘churn’ rate – members joining and quitting – they must continually pursue new users to replace those who cancel their membership. They usually do this through a mix of software development to make their applications more desirable to more customers, and intensive marketing to leverage current members and extract more fees per user in exchange for enhanced service features.

The main selling point of SaaS organisations is the central management and development of their applications. Customers do not have to buy and install software on their local systems or replace or upgrade as applications become out of date. Because users have direct access to the applications via the cloud, it is generally viewed as being more efficient and economical than ‘purchase to own’ alternatives.

Key benefits of SaaS include:

• Economical: No large upfront payment, subscription spreads cost over time.
• Mobility: In theory, users can access the software anytime from anywhere.
• Easy updates: Central management of the software saves users having to install new versions of the application as the old ones become obsolete.
• Scalability: If the customer needs more services, or wants to add more users to its membership, it simply pays a higher subscription.
• IT expertise: SaaS companies invest heavily in developers and IT specialists – giving users access to a large knowledge pool they probably could not assemble or afford themselves.

The biggest disadvantage of SaaS companies is the infrastructure that houses the applications members pay to use. Due to the high cost of construction, maintenance, and the massive energy supply required to run large networks of computers, many SaaS businesses outsource this need to supplier data centres. This means the SaaS provider does not actually control the hardware that hosts the software they sell – leaving the SaaS company vulnerable to outages they cannot fix, scalability issues, and the financial strengths or weaknesses of the data centre.

Key issues of SaaS include:

• Downtime: If the data centre has a problem, then the SaaS company has a problem – which means their members have a problem that can easily cascade.
• Pricing: SaaS businesses must pass on costs through subscription fees. Users may find it hard or impossible to step out of a long-term contract even if their fees are rising fast.
• Inflexibility: Users who wish to downsize their membership may find they cannot do so until a lengthy notice period has passed.
• Security: Third party data centres are housing user data. Security effectiveness can vary wildly, with the potential to expose the SaaS company and their users to data breaches and loss.
• Financial strength: SaaS applications are only as strong as the SaaS company managing them. If they become insolvent, the application may cease to operate, leaving users without an alternative or access to their most important information.

SaaS has the potential to solve many types of business need. Some of the most popular uses include:

• Accounting and invoicing.
• Human resources - workforce management and recruitment.
• Customer resource management (CRM) – handling customer and sales information.
• Project management.
• Marketing and networking.
• Web hosting and ecommerce.
• Data management.

Bringing a new SaaS company to market requires ingenuity, resources, and planning. Entrepreneurs seeking to launch a SaaS startup or SaaS businesses seeking further growth will usually need external funding to make their ideas a reality.

There are five stages to finance a SaaS business:

• Pre-seed: Funds to get the project off the ground and create software prototypes. Possibly fund a beta version for testing. Pre-seed funds often come from private resources – the entrepreneur, friends, family.

• Seed: This is where the business moves out of first gear and reveals products and potential. Funding may launch the service into the market, obtain partnerships, pay for market research, hire staff. Loans and equity financing become a possibility.

• Series A-E funding: The middle ground of the financing process and where the business takes on mass to become an established force. Five rounds with designations from A to E. Each round larger than before. Large-scale lender and VC funding enters the scene.

• Mezzanine financing & bridge loans: The last stage before the business opens on the stock market. Funds prepare the company for floatation and are often loans that can be converted into shares when the company goes to IPO.

• IPO – Initial Public Offering: The final stage. The business launches on the stock market on boards. The public can now buy shares in the business. Often, this is where founders and early investors sell stock to convert their effort and risk into hard earned cash.

Some SaaS businesses may seek to avoid paying interest on borrowed funds or giving up ownership with equity financing. To do this, they may choose revenue-based financing (also called non-dilutive capital) to fund their growth and operations. With SaaS revenue financing, the technology company will pledge a percentage of their gross income to the investor/lender, usually making payments every month. Payments will continue until the investor has received a multiple of their invested sum – typically four or five times invested capital.

This type of arrangement may suit SaaS business who can demonstrate strong and regular income. It is cost effective and retains full ownership, as the company pays no interest or surrenders equity, and they only pay a percentage of their income not a fixed sum each month – which means when money coming in is low, payments going out are low.

Debt-based financing for traditional companies has been in existence for many years. Simply put, it’s a loan secured by the company’s hard assets – buildings, land, plant, and inventory, etc. SaaS business typically have few or no hard assets to offer as collateral. Instead, debt-based financing for these types of technology companies is based on the potential of the business not what it owns. Often the lender will take security in the form of a warrant – which allocates equity in the case of borrower default.

Debt-based financing is often utilised alongside equity financing because it allows the company to secure more funding without giving up more ownership. Lenders will typically charge higher interest rates on SaaS debt financing that on traditional collateralised lending to offset the added risk.

Bessemer’s 5 c’s of SaaS (or cloud) financing pinpoint the important metrics that every SaaS company must track if they wish to be successful. They reveal financial health, customer retention and acquisition, cash burn-rates, customer lifetime values, churn rates and more. Lenders and investors will usually refer to these metrics when making a funding decision.

The five c’s:

• CMRR, ARR, & ARRR – Committed Monthly Recurring Revenue, Annual Recurring Revenue, and Annual Run Rate Revenue – reveals long-term financial viability.
• Cash Flow – start with Gross Burn Rate and Net Burn Rate, then hopefully turn to Free Cash Flow (surplus) over time – shows how fast the business is spending in contrast to what it is earning or raising.
• CAC – Customer Acquisition Cost Payback Period – how long it takes to recoup the money spent on securing a customer.
• CLTV – Customer Lifetime Value – what each customer is worth during their membership and how that translates to the costs of retaining the customer.
• Churn & Renewal Rates – Logo Churn, CMRR Churn, and CMRR Renewed – the speed with which customers join and quit their membership and how fast leavers can be replaced with new members.

Funds can be used for a variety of purposes, including user acquisition, marketing spend, product development, recruitment etc. Some lenders restrict the use of funds whilst others may simply forward the advance to your bank account.

No matter if you’re just starting out or a well-established company, there’s a financing plan to help you take the next big step. Find out more about the funding options for your SaaS business by registering with Swoop.