By Scott Bergquist
In December, Google announced its launch into the public cloud as a direct assault on Amazon, IBM and Microsoft, betting it can be the systems infrastructure for corporations. Businesses of all kinds will be built on top of such computing power and storage capacity. But how are SaaS (software as a service) and IaaS (infrastructure as a service) vendors (other than the giants) going to be capitalized and financed to enable the next leap in cloud computing?
Relative to the enterprise software sellers of the past, SaaS companies require less upfront dollars to build infrastructure (e.g., servers). By some estimates, the application company of the past required 10x to 100x the capital to realize the same enterprise value. But SaaS companies confront greater working capital challenges. Those challenges come from client acquisition and on-boarding.
Recurring revenue business models are also uniquely measured. The metrics are committed monthly recurring revenue (CMRR), customer lifetime value (CLTV), customer acquisition cost (CAC) and customer churn. For a SaaS company, these distinct attributes help determine enterprise value and the likelihood for sustained growth in value over time.
The inherent “stickiness” of recurring (and committed) revenue yields a valuation premium over traditional enterprise license, or non-recurring, sales models. But financing such models requires working capital and growth capital structures that are non-traditional.
Capitalization Scenarios
Financing cloud-based businesses can be difficult through traditional means. That’s because recurring models make a trade-off at inception: a lower-priced perpetual revenue stream with higher long-term value, versus a traditional revenue stream with higher initial price but lower long-term value.
The recurring revenue model can be worth more over time and require less capital to fund. But fixed assets, front-loaded expenses associated with client acquisition, and on-boarding put demands on the internal cash flows, debt, and equity needed to support growth.
Cash Flow. A few cloud-based companies are able to capture sufficient cash flow to grow organically without institutional capital. Few can do so without the benefit of a cash-cow elsewhere in the business, though. In the SaaS model, there is an inherent mismatch between client acquisition expenses and subscription revenues. Client acquisition costs (CAC) can equal several months of revenue, putting enormous pressure on a fast-growth company to manage a positive working capital position. As growth rates are king for SaaS companies to stay competitive, it is difficult to pare back these sales and marketing expenses, and revenues will not flow until the software is successfully installed and integrated with existing systems — both are material, front-loaded expenses. Accordingly, fast organic growth exceeding 80 percent CAGR is rare, except for a company with a product that is “pulled” into a large market opportunity and is relatively self-serve for new clients to load and run.
Debt. Recurring revenue models, like cloud-based SaaS and IaaS, provide a strong platform for leverage with or without positive cash flow. A few bank and nonbank debt providers are delivering “recurring revenue lines of credit” (RRL) to address the strain that front-loaded client acquisition costs can put on working capital and precious equity. RRLs are a relatively new debt product. They require an untraditional underwriting approach, as the borrowers do not have adequate supporting assets (like accounts receivable) or cash flow.
Broadly, debt providers are willing to lend a multiple of several months’ revenue on the premise that committed monthly recurring revenue (CMRR) is highly predictable and sales expenses are variable — and decoupled. Unlike a company that sells widgets, a high percentage of a SaaS company’s forward top-line revenue will be already baked and independent of any incremental marketing spend. Accordingly, RRL commitments range from 1x to 12x CMMR. This is possible because a lender’s downside modeling will show that existing client revenue can be quickly turned into cash flow and service such debt loads. Lenders factor growth rates, revenue granularity, client churn and billing frequency into their borrowing formulas. Companies with positive EBITDA can find even more aggressive borrowing multiples beyond the aforementioned range.
Equity. Institutional equity is a preferred path for fast-growth SaaS companies that are selling, marketing and on-boarding at rates that can double top-line revenues year-over-year. While equity represents the highest-cost capital for an entrepreneur, it can also accelerate enterprise value and offers inherent advantages: committed funds, flexibility relative to debt and certainty relative to yet-proven organic cash generation. The cost or valuation multiple will be a function of current sales and forecasted, defensible net growth rates. Many investors have modeled (as Scale Venture Partners has) that companies will need initial growth rates in excess of 80 percent and not slow that growth more than the norm of 10 percent to 20 percent per annum to achieve a targeted venture return of 10x in five years.
Companies interested in financing their cloud-based business via an external debt or equity source must have tracking and reporting tools that explain the real performance metrics that drive value in their businesses. The best cloud-based managers are data geeks, relentlessly measuring and making adjustments to front-end sales or back-end support in pursuit of increasing acquisition and retention.
Additionally, early and periodic conversations with potential financiers are critical to optimize timing and cost. For example, an RRL facility could be the perfect tool to help reach a significant recurring revenue threshold before securing a larger equity round with significant step-up in valuation.
Scott Bergquist is the central U.S. division manager for Silicon Valley Bank, overseeing business development and client relationship activities with 2,000 companies and managing more than $1 billion in committed capital. He specializes in financing solutions for high-growth technology and life-science companies. Gary Jackson of Silicon Valley Bank in Salt Lake City contributed to this column.
Source: CFO.com
