Recurring revenue, unique financial metrics, tailored funding: financing SaaS startups work with different criteria than traditional corporate funding. What do SaaS companies need to pay attention to when considering finance?
What is SaaS financing?
SaaS financing is a specific funding option for companies that offer software-as-a-service or a subscription-based business model.
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.
The phases of a SaaS company
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.
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 funding, the founders' capital, business angels, or investments from friends and family are at the table.
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. Depending on the case, the company may open to venture capital investors or business angels and raise venture capital funding.
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.
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.
For that, equity and debt financing can be useful – depending on the company's goals and needs.
Company phase determines 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.
Financing decisions should be carefully considered in advance. Depending on the type of financing, the company's shares may be heavily diluted. In the current environment, the cost of capital also plays an essential role.
Types of SaaS financing for startups
A variety of funding models are available to SaaS companies. 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.
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.
Venture debt describes raising a risk loan shortly after or at the same time as venture capital financing. A startup accesses saas 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.
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.
Metrics and KPIs that are 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
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.
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.