TLDR: If you don’t want to go down the traditional VC path and sell equity in your SaaS company, here’s a spreadsheet of 50 lenders who’ll give you money.
There are only 2 ways to raise capital for your software company to drive growth.
You can raise debt, or you can raise equity. Over the past 10 years, investors (equity) and lenders (debt) have standardized different mixes of the two to give more freedom to entrepreneurs.
Today, there are 6 main combinations of debt and equity that SaaS founders can raise on:
In this article, we’ll focus on each of the 6 options and then run a scenario comparing the options for a company doing $2 million in revenue that wants to raise $1 million.
1. Traditional Equity
Equity is what you’re most familiar with.
This is when you raise a Seed round from angels who buy a % of your company.
You might raise $2 million on an $8 million pre money valuation which means you sold investors 20% of your business.
This scales all the way up to a $80 million revenue company raising a $100 million Series D, 12-18 months before their IPO.
Examples: Battery, a16z, FirstRound, Founders Fund, Kleiner, TCV
2. Convertible Notes or SAFE’s
These allow you to raise capital today with an interest rate, usually 6-8%, a valuation cap, and sometimes a discount (usually 20%).
This isn’t really debt though. Investors using a note or SAFE are not going to ask you to pay it back.
They want you to grow and then convert them to equity. This is a fast and cheap method to approximate equity value ahead of an anticipated equity round.
Examples: Any early stage VC Fund like ActiveCapital, or angel investors
3. “Shared Earnings” and SEAL’s
These come in a variety of flavors with the basic idea being if the founders generate profit, investors get paid a 3-5x return over some period of time, and still have ability to participate in equity.
Earnest, TinySeed, and IndieVC are the players here. Remember to put this in context. This is a very new concept with less than $20m being deployed from all 3 of these investors combined over the past 3 years.
This is Earnest Capital’s term sheet. As founders pay themselves salaries, you pay back Earnest 2-5x their investment. Unlike Indie.VC there is no “repurchase start date”. If founders don’t pay themselves salaries, and their is no net income, you’d owe Earnest nothing. Obviously this isn’t reasonable because founders have living expenses and will eventually take some salary.
Even if you pay Earnest back, they retain whats called an “Equity basis” which acts like a SAFE and enables them to convert their investment to equity.
This is Indie.VC’s term sheet, sweet spot $300k investment in exchange for ~10% equity. After a period of time (repurchase start date) if you don’t sell or raise traditional equity, you must start paying back this $300k as a % of your gross revenue each month until you pay back $900k (3x cap). As you do this, you “buy back” up to 9% of the 10% equity IndieVC took.
TinySeed terms are listed here. They’ll invest $120k for 8-15% of the business. They set salary cap with the founder. If company generates profits, TinySeed gets dividends on pro-rata basis. TinySeed has right to participate in next round of equity financing and their investment converts.
4. Revenue Based Financing (RBF’s)
If you know you can put $1 in your SaaS “sales machine” to get $2 in new annual recurring revenue, you might use revenue based financing (RBF’s).
If you’re doing $1m per year in revenue, you could raise up to $500k (1/2 your ARR), and pay back 1.5x, or $750k, over 4 years by paying 3-10% of your gross monthly sales every month.
Examples: LighterCapital, TIMIA
5. Mezzanine Debt
For B2B SaaS companies, there are many lenders who take first lien on your business (Senior Debt) who will offer up to 6x your MRR at mezz like returns (16-25% interest rates).
These lenders typically take 0.1-0.2% warrants and also ask for financial covenants.
Examples: SaaSCapital, Espresso Capital, BigFoot Capital
6. Senior Debt
This debt is the cheapest because there’s “less risk” to the lender. Founders pay this back at a flat 4-7% interest rate, usually paid out monthly. You have to be building a SaaS company that is “de-risked” to get this kind of debt.
“De-risked” could mean that you’ve raised traditional VC so there is a “backstop” for the senior debt. It could mean that you’re growing at a healthy rate without burning a ton of capital.
Generally, once you’re bigger than $10m in revenues, Senior Debt lenders become an option for you.
Examples: SVB, CIBC, Hercules
Now that you have a high-level understanding of the 6 different ways you can use debt and equity to raise money for your SaaS company, lets explore a real life scenario.
For a company with $2m in revenue that wants to raise $1m, whats cheaper?
Debt or Equity?
6 Ways For a Company Doing $2 Million to Raise $1 Million
Lets say that you’re a bootstrapped founder with $2m in revenue (ARR) and you want to raise $1m to grow faster.
You have a good idea about your customer acquisition cost (CAC), and you’re growing 50% yoy.
You want $1m to hire some sales representatives, increase ad spend, and hire 2 engineers to accelerate product development.
For us to calculate cost of capital, lets assume you use this $1m to grow the business 4x over 4 years to $8m in revenues.
Equity Example:
To raise $1m, you’d sell about 10% of your business. I’m assuming a 10m valuation, a 5x valuation multiple, on $2m in ARR. If your company grows to $8m in ARR in 4 years, your company is worth about $40m assuming the 5x multiple doesn’t change.
That 10% you sold 4 years ago for $1m is now worth $4m.
You “paid” $4m to 4x your business over 4 years.
Convertible Note Example:
You would raise $1m on a note at a cap of $10m, interest rate of 8%, and discount of 20%.
Lets say you used this $1m to grow and then raised a $10m Series A 4 years later at a $40m pre money valuation.
Convertible note investors would end up with 13.2% worth about $5.2m. In this example, this is “more expensive” than raising $1m in straight equity at the start because of the discount rate and interest found in most convertible notes.
The upside for founders is added flexibility.
You “paid” $5.2m to 4x your business over 4 years.
*Click image to use live calculator
Shared Earnings Income Agreement (SEAL) Example:
To raise $1m, you’d sell about 10% of your business but you’d have the ability to buy back up to 9% of that equity for $3m.
That 9% you sold 4 years ago for $1m is now worth $3.6m but you had to pay $3m (3x the initial $1m you raised) to get the 9% back.
When the dust settles, investors own 1% of your $40m valuation business (worth $400k), and you paid $3m in cash to get back your other 9%. In total, you paid out $3.4m over 4 years to get that initial $1m.
I’m oversimplifying in the chart below. Payments are not actually equal every month.
With these assumptions, effective interest rate on $1m in and $3.4m out over 4 years is about 81%.
You could also wait for more than 4 years to buy back the 9% which would drive interest rate down from 81%.
However, even if you waited 8 years to pay back $3.4m on the $1m, you’re looking at an interest rate of 41% (some would say expensive!).
The upside of this model is the entrepreneur decides whether to pay back the capital or not. If the company does well, you can pay it back from cashflow. If the company doesn’t do so well, you let the investors keep 10%.
You paid back $3.4m and grew your business 4x over 4 years.
Revenue based financing (RBF’s):
To raise $1m, you’d sell no equity but you’d have to pay back $1.5m over the next 4 years (repayment cap).
At a $2m run rate, you’re doing $167k/mo when you raise this $1m. You’ll pay this loan back using 6% of your monthly gross receipts, or $10,020/mo ($167k*.06).
Lets say every 6 months you increase MRR by about $50k because you intelligently invested the $1m you raised.
6 months after the raise, you’re doing $217k/mo in revenue paying $13,020/mo (6% of $217k) to pay back the debt.
Let us continue with the growth story, 18 months in and you’re killing it. Now you’re up to $300k/mo adding $30k in new MRR every month. The 6% you’re paying back monthly grows quickly. Now you’re paying back $18k/mo (6% of $300k/mo).
If you continue this kind of growth, you’ll pay your loan back way before its 4 year term ends. This would make your cost of capital much higher.
Let us assume though that you grew revenue at exactly the rate you needed to payoff the loan in line with the 4 year term.
Even in this perfect (cheapest) scenario, you’re paying an interest rate of 22%.
The good news is you grew your MRR from $167k to something well north of $525k. I calculated that by taking the payment in month 48 of $31,506 and dividing by 6% (the monthly money you owe on the loan).
(RBF’s can get very expensive)
If you grew faster, you’d pay off the loan faster since its tied to 6% of your monthly revenue, and this would drive your interest rate up.
If you grew way slower, you’d have to pay back a big chunk of principle at the end of the 4 year term. This is cash you’re not likely to have sitting in your bank to actually payoff.
You’d likely try and renegotiate with the debt provider, but since they have most of the leverage, you’ll end up with an even higher interest rate and other bad terms you don’t want.
Its notoriously hard to model the true cost of capital on an RBF. I’m giving you examples so you can understand relationships between the key terms then make up your own mind.
If you used the $1m loan to grow revenue from $2m a year to $8m+/year, assuming the valuation multiple of 5x didn’t change, the 10% you saved from not selling equity (and using RBF instead) is now worth something like $4m.
Instead, you raised $1m in capital, paid back $1.5m and grew your business 4x.
Mezzanine Debt:
To raise $1m here you’d pay a straight interest rate. Of all the term sheets I’ve looked at, they typically fall in the 17-22% on a 4-6 year term.
Lets assume a $1m raise at 18% on a 4 year term. Your monthly payments would be $29,375 consistently each month.
Sometimes these lenders will give you an interest only period of 6-12 months which is nice. This enables you to start driving some growth with the $1m you raised before you have to start paying back principal.
Sometimes these lenders will also have warrant coverage equal to the value of 5%-20% of what they loan (so $50k-$200k of warrants on a $1m loan). At a $10m valuation, those warrants effectively equal .5-2% of the company.
Most friendly lenders here will not require warrant coverage or strict financial covenants like “keep 6 months of burn in cash at all times”.
In total, you raised $1m in capital, paid back $1.4m and grew your business 4x.
Senior Debt:
This would be pretty straightforward. A bank like SVB would give you a credit line of $1m and you’d owe 5% interest on however much of the $1m you’ve used (lets assume you use all of it).
They’d take 20-50bps (.2-.5%) in warrants. 0.5% of a $10m company is $50k.
This sort of facility is only available to those founders with VC backers, loads of cash in the bank, or otherwise very low risk.
4 years later when you grow to $40m valuation using the $1m line of credit, those warrants are worth $200k and you’ve paid the bank $105k in interest on the $1m you took from them.
You paid $305k to 4x your business.
Merchant Cash Advances:
Merchant cash advances are tricky to directly compare to everything else because its a very different facility. These advances are usually very expensive and are a multiple of your monthly revenue.
A new breed of lenders are popping up in this space like Stripe Capital, ClearBanc, Paybal, AMEX, and others.
The cost of capital is usually marketed as a “fee” versus an interest rate. You should try to calculate the cost of capital by understanding how long you have to pay it back (interest depends on time it takes to pay back).
For example, you’re selling $250k per month in product, maybe you get a merchant cash advance of $500k and pay it back over 6 months with 15% interest (so 30% effective APR).
Summarizing Your Options as a SaaS Founder:
Use this chart to get a snapshot of your options but please remember the details of each option.
* Equity, Notes, and SEALs are not meant to be debt facilities
It would be a mistake to only look at APR’s to compare Equity vs. Debt (you don’t actually have to pay out cash/interest on Equity rounds).
The real upside to debt over equity is that it allows you to keep all of your equity, but you must pay back cash.
The real upside to equity is that it allows you to bring on smart people who are motivated to help you go build a massive company.
Your job is to not run out of cash
In conclusion, a CEO’s top priority is not running out of cash.
As you think about your options, consider this question:
If you take money and fail to grow the business, is debt or equity more likely to kill you?
Further Reading:
https://tomtunguz.com/venture-debt-spike/
VC perspective on why debt is exploding: http://christophjanz.blogspot.com/2017/05/the-growing-dissonance-between-two.html
VC on why they have to pass on “really good” SaaS companies: http://christophjanz.blogspot.com/2017/05/the-growing-dissonance-between-two.html
