What does SaaS stand for?

SaaS stands for Software as a Service, which includes a wide variety of companies in the B2B and B2C space. Many of the world’s most prominent companies offer SaaS products, and most people use at least one form of SaaS in their daily life. For example, Google is the world’s most important provider of SaaS products, and the company’s Gmail SaaS software is used by around 1.5 Billion people around the world. SaaS companies are in big business, and it’s no wonder that finance providers have adapted to cater to the industry’s needs.

Why are SaaS companies different?

A successful SaaS company generally has a fairly typical trajectory, and a few key factors can influence it. The life cycle of this type of business usually includes an initial stage that is very cash-intensive, where the company does a lot of R&D and develops the product. There is nothing yet to sell at this stage, usually, or there are beta variants of the software that are tested through small internal groups and early adopters.

The next stage is usually built on creating positive network externalities – most SaaS products are built with positive incentives for users to recruit their wider network. The clearest case for these positive externalities is within social networks like Facebook. The value of being part of the platform is wholly dependent on who else is on it. But these types of dynamics are everywhere now – from Uber’s famous friend discount codes to simply paying users to have friends and family join up through vouchers. This stage is usually when revenue starts to trickle in, but the cost of building the user-base outstrips it. In both B2B Saas and B2C SaaS, this phase is usually the most costly.

The third stage is based on leveraging the network effects and increasing revenue, which is usually reported in the form of MRR/ARR (monthly/annually recurring revenue). A typical SaaS business is finally on its way up at this point, after a very costly start. But for the promise of enormous scale and exponentially increasing revenue, it is worth it.

The fourth and final phase is either exit – the company is sold to or merged with a bigger competitor or one of the world’s multi-functional software giants – or continued growth based on reinvested revenues.

What are the essential SaaS financing options?

Because of the nature of the SaaS business lifecycle, the search for the best funding options for SaaS companies needs to take into consideration the initially very expensive runway required to build the product and create a user base. Financing, in the beginning, will need to focus on the assets the company already has: a vision and the R&D.

Financing the Vision: Seed-stage VCs and Angels

In the initial, capital intensive stages of a SaaS business, the company needs to rely on someone who believes in the vision backing the company’s cash flow. This is initially usually the founder and his immediate circle. Still, if they can convince an Angel or a Seed stage VC fund of the plan for customer acquisition and creating that all-important monthly recurring revenue, they have an excellent basis to start the second phase. If the SaaS metrics fit the needed parameters to scale, then series A funding is usually the next step.

Growing after MVP: Series A

Series A capital is usually available to a SaaS company after the initial track record has been proven. This means the existing customers are retained, and new customers are added at a sufficiently steep pace to pique institutional investors’ interest. At this stage, the product is still evolving, and a lot of R&D means that different avenues are available.

Scaling a great product: Series B and beyond

Once the business has proven that it can create user value, attract a significant number of customers, and create scaling revenue, it is in a great spot to put fuel on the fire. Series B funding and further rounds are usually structured as growth rounds. They may involve other instruments like venture debt and attract different types of investors, like private equity companies and more specialized growth funds.

Making use of the asset: R&D Finance

Getting debt finance beyond venture debt in more advanced rounds has been a challenge for SaaS companies. A B2B SaaS CFO may not even be aware that they have an asset on P&L to leverage for necessary cash flow. If the software company has invested a lot in R&D, which is the case for most, it pays to make sure if the company could be eligible for the R&D tax credit and R&D finance. SaaS businesses typically are oriented toward equity finance, but adding some affordable debt into the mix offers several advantages:

• It helps prevent equity dilution: If the company is set to go through several rounds of funding, the founders’ stake tends to diminish steeply. In Silicon Valley, it is not unheard of for founders to end up with a small fraction of their initial equity after many years of hard work. Any action that a founder can take to protect equity early on is usually worth taking.
• It creates a stronger negotiating position with equity investors. Dependence on new money inflows pushes the founders into a tight corner. With an influx of R&D Finance and the resulting extension in the runway, the business has a bit more security, doesn’t need to generate revenue as fast, and has the time to select its new investors wisely.
• Because deferred revenue is a big subject in SaaS businesses, creating a buffer for the months in which the MRR is not up to projections is vital. R&D Finance can help there.
• It is accessible to pre-profit and even pre-revenue companies, which is the case for many SaaS businesses in the initial stages of growth.

Scaling as you scale: Revenue-based finance

A host of new lending companies have entered the market to service SaaS businesses with financing against their MRR. Because most SaaS businesses invoice every month, even if their annual turnover is high, these funds are stuck as deferred revenue. MRR-based lending helps bridge this gap and offers companies, often in B2B SaaS or even in B2C, loans guaranteed against their incoming revenue. The application process for these loans is typically simplified, and access to capital is fast. A constraint is that early-stage SaaS companies are generally ineligible because they are pre-revenue.

The Wrap Up

A SaaS business has an increasing variety of funding options that consider the lifecycle of this market. From the massive investment in R&D early on to the importance of deferred revenue to its P&L, network externalities, and the trap of long-term pre-profit status, a wide variety of both equity and debt providers have stepped in to fill the gaps. If you think we’ve missed something or want to add your two cents to the discussion, please leave a comment below.