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Financial Implications of the SaaS Business Model
By Todd Gardner, CEO, SaaS Capital
The Software as a Service (SaaS) market is growing rapidly in response to a variety of macro-market trends. Although the rapid growth of SaaS offers an exciting time for entrepreneurs and established software vendors, the SaaS model also poses significant business challenges – not the least of which is cash flow. The good news for SaaS vendors is that the very financial elements that make SaaS companies require more capital are the qualities that make them good borrowers. This article discusses how the pay-as-you-go, subscription model is driving aspiring SaaS players to pursue funding alternatives to support their business operations.
The Software as a Service (SaaS) market is growing rapidly in response to a variety of macro-market trends. These drivers are encouraging organizations of all sizes to consider and adopt a widening array of SaaS alternatives to traditional on-premise software applications.
Although the rapid growth of SaaS offers an exciting time for entrepreneurs and established software vendors, the SaaS model also poses significant business challenges – not the least of which is cash flow.
Pay Me Now or Pay Me Later
One of the largest challenges of the SaaS model is obviously payment terms. Getting paid monthly or quarterly versus getting paid one very large check up front is the major driver of the need for more cash to fund operations. Even getting the first year’s payments all in advance is still significantly less cash than the perpetual model. The chart below shows, assuming the same selling cost, the dramatic difference in cumulative cash burn based on when the software company gets paid. This leads to a cash flow squeeze, as cash coming in significantly trails bookings. Bottom line, a SaaS company can take 50 – 70% more capital to grow than a perpetual license model company.
The Costs of Capital for SaaS vs. Perpetual License Software Companies
Cumulative Cash Burn
Sales and Marketing Costs
While many of the enabling technologies and services for SaaS are relatively inexpensive compared with the large investments required to build and support legacy applications, the costs of acquiring and supporting SaaS customers is significant – particularly as a percent of revenues. A review of SaaS company IPO filings shows that large amounts of investment in operations (sales, marketing, hosting and professional services) were required to launch SaaS companies – sometimes at a rate of 2x revenues. For example, NetSuite Inc.’s recent Securities and Exchange Commission (SEC) filing for its Initial Public Offering (IPO) clearly shows the large sales and marketing costs for acquiring SaaS customers. The filing showed that NetSuite generated $17.7 million in revenue in 2004, $36.4 million in 2005, and $67.2 million in 2006. However, its sales and marketing costs surpassed revenues in 2004 and 2005, equaling $27 million in 2004 and $39.2 million in 2005. It wasn’t until 2006 when NetSuite was able to spend ‘just’ 53% of revenue on sales and marketing. SuccessFactors has also submitted SEC papers for an IPO that show the company spent $32.3 million – 99% of revenues – on sales and marketing.
Off note, however, the high selling cost as a percent of revenue does not mean the total costs are actually higher. Instead, to a large degree, it reflects how the revenues are recorded in the SaaS model. For instance, if a traditional ISV has three sales people each costing $100,000 a year in salaries and commissions, and they generate $1.5 million in perpetual licenses in Q4, the selling cost as a percent of revenue is 20% for that year. However, if a SaaS vendor has the same three sales people sell $1.5 million in three-year contracts in Q4 the selling cost would be 240% because only a small portion of the revenue is recognized. On a cash basis, many of the expenses are paid out before the cash is received from the customer.
It All Adds up to More Money
While the annuity stream of SaaS companies has become increasingly attractive to the investment community, Will Price of Hummer Winblad Venture Partners estimates that it takes 1.6x longer for SaaS companies to become liquid compared to traditional software companies and requires 1.75x more revenue and 3.65x more capital to achieve profitability. Our research confirms his assertions and a listing of recent SaaS IPO’s reflects the capital intensity of the model.
Pre-IPO Equity Investments in SaaS Companies 2004 – 2007
Company Pre-IPO Equity ($000) IPO Year
RightNow $31,740 2004
Salesforce.com $88,570 2004
Black Board $130,032 2004
Kenexa $71,408 2005
Dealer Track $79,907 2005
Omniture $54,508 2006
Of the last 6 IPO’s of SaaS companies, the average amount of venture capital raised was $76 million prior to IPO. This amount of capital is not only dilutive to the founders and common shareholders; it’s dilutive to the VCs as well who are striving to be equity efficient.
Since SaaS companies can take 50% to 300% more cash to build than traditional perpetual license software companies, financing all the additional cash needs with equity funding is not an efficient use of capital for the VCs, founders or management team. It’s an expensive way to do it both for the VCs and all the other shareholders, including dilution to management, as the model tends to lead to Series C, D, E, and then AA, etc.
On the flip side, technology-focused banks are constrained by the lack of traditional sources of repayment, namely profits and/or assets, both of which are in short supply for an emerging SaaS business. Unprofitable businesses with little in the way of assets are a mismatch for banks. As a result, few of these institutions are willing to lend much in the way of funds to SaaS companies to meet their working capital needs. The structures they do provide can help, but are typically confined to 60 day accounts receivable loans, or loans to purchase servers or other hardware.
The emerging products of venture debt companies are an option for SaaS companies. These lenders are more aggressive in their approach and are not constrained by regulatory issues. The big drawback with venture debt, however, is the structure. They are most aggressive about lending to SaaS companies when they have just raised an equity round. That is precisely when the company does not need the cash. Borrowers end up spending a lot of money paying interest on debt they don’t yet need. By the time they do need the cash, the loan has been amortized down and they are left with debt service, not liquidity. Venture debt can be even more expensive when the value of the warrants is considered.
Unlike perpetual license counterparts who typically have highly variable revenue streams, SaaS companies are actually good candidates for debt. The stable cash flows, high margins and discretionary expenses of SaaS provide a strong foundation for lending for those who understand the model.
SaaS Capital has created a new approach to debt financing for SaaS companies. By looking past the lack of profitability or assets, SaaS Capital focuses on the key strength and inherent value of the SaaS model in order to let SaaS companies monetize a portion of their unbilled future cash flows. Set up much like a line of credit, the debt facilities are designed to provide growth capital when needed and also to grow with the business. So, as a SaaS company’s bookings grow, so does the size of the line. Typically, SaaS Capital is structuring facilities, which advance three to four times monthly recurring revenue. For software companies with long-term contracts, SaaS Capital typically advances 30% to 50% of the unbilled contract value.
Additionally, SaaS Capital has the capability and expertise to provide operational/technical services. They have the capacity to run an underlying SaaS application if they need to, which is what allows them to lend against future unbilled and undelivered revenue. It’s also a capability that many of their customers discuss with their larger clients and prospects who might be concerned about vendor viability issues.
Because of its specific focus, SaaS Capital can assess the debt service capability of SaaS companies quickly and lend them enough capital to meet their operational needs. It’s also very important not to over leverage the business too early in their growth cycle. Debt is not a substitute for early stage venture capital, and SaaS Capital’s customers have already reached more then $3 million in recurring revenue before they leverage their business in a meaningful way.
Todd Gardner is CEO of SaaS Capital, a specialty finance company that provides lines of credit to emerging software-as-a-service companies. He has spent his entire professional career in the finance and software industries. As an outgrowth of his venture work with software companies and ASP providers such as US Internetworking, Todd came to recognize the benefits of the SaaS model and its financial and cash-flow implications. Finding no good financing solutions for his SaaS portfolio companies, he pulled together a team of software finance and SaaS technology veterans to launch SaaS Capital at the end of 2006. For the 10 years prior to launching SaaS Capital, Todd was a partner at Blue Chip Venture Company where he focused on investing in early-stage software companies. While at Blue Chip, he directly led new investments in many different companies, including financing rounds ranging from $500,000 to $25 million. During Todd’s tenure in the venture capital business, he maintained a 100% success rate in software investing even during challenging investment cycles following the technology bubble of 2000. For article feedback, contact Todd at firstname.lastname@example.org