Alternatives to Traditional Venture Capital Equity Financing

Get Funded While Retaining Control

SaaS companies face challenges getting funding from traditional lenders. There are several reasons for this, including lack of positive cash flow and the absence of hard collateral. However, as the SaaS business model has matured and become better understood, an increasing number of institutions are willing to provide alternative, non-equity, or hybrid, types of VC funding to solid SaaS companies.

This post will look at the different types of funding that are available, some of the pros and cons of each, and when they might make sense.

Venture Debt

Venture debt is a tranche of debt financing provided to venture-backed companies most often in conjunction with, and as a complement to, an institutional round of funding. Venture lenders will make loans to companies that are not cash flow positive. These loans typically amount to 30 – 50% of the equity round. To compensate for the additional risk of default the lender will sometimes require an “equity kicker” to juice their returns (i.e. warrants or equity purchase rights). The warrants are held by the lender until a later date, usually when there is a liquidity event. At that time, the lender exercises the warrant and benefits from the increased value of the stock just as an option holder would in a transaction. That additional value greatly increases the lender’s return on the original debt and serves as an incentive to them to make such a loan in the first place. Remember, when negotiating all equity related terms – nothing is more valuable to the company than its equity and it should be allocated carefully.

Example:

Venture debt can be used to:

1. Minimize the equity dilution in a round of funding by augmenting the amount raised in a less dilutive manner.
2. Extend the cash runway before the next round of equity funding thereby enabling a higher valuation resulting in less dilution to existing equity holders.
3. Extend the cash runway to the point of achieving cash flow positivity thereby enabling the company to skip its last round of dilutive funding.
4. Enable a company that is off plan (e.g. as a result of the impact of COVID) to avoid a potential down round by providing sufficient bridge funding to enable it to attain milestones that will facilitate an up round.

While venture debt can be a useful tool, it’s not a default funding option for every startup. Unlike equity, venture debt must be repaid with interest.

Revenue Based Finance (RBF)

Revenue-based financing, as the name implies, is a funding mechanism whereby invested capital is repaid from a fixed percentage of ongoing gross revenues. Repayments continue until the initial capital plus a multiple (also known as a “cap”) is repaid.

While it is not necessary for the business to be cash flow positive or to have any collateral, it must have substantial current revenue, a revenue growth rate of 20%+, and it generally works best for those companies that generate high gross margins on those revenues. These are attributes that apply to many SaaS companies.

Unlike a traditional amortizing term loan, RBF repayments are structured as a fixed percentage of monthly revenue. Payments continue until the investor has received an agreed multiple of invested capital (anywhere from 1.35 – 2.0X invested capital.)

Each lender has their own criteria, but the following is a guide as to the range of terms that might be expected.

• Loan amount: $200k – $5M based on 4 – 6X monthly recurring revenue (MRR).
• Repayment amount: 2 – 8% of monthly gross receipts.
• Repayment term: 3 – 5 years.
• Repayment cap: 1.35X to 2.0X invested capital (depending on estimated term of the arrangement).
• Maturity: 5 – 8 years (the time at which business would make a full and final payment to investors to reach their maximum total return, if that amount had not been reached yet).

As interest in revenue-based financing (RBF) has grown, and acceptance has increased in the investor community, numerous institutions have emerged to compete for the business. Funding growth through RBF offers many of the benefits of traditional venture capital funding without some of the perceived drawbacks. Some of the advantages of a typical RBF facility are as follows:

• Faster time to close
• Flexible facility – the facility scales as revenues grow and multiple draws are available once payment history is established.
• No covenants.
• No personal guarantees.
• Reporting requirements are not onerous.
• Non-dilutive. No warrants required. (NB there are some niche lenders that offer a hybrid model where they take an equity kicker and a lower cap).
• No board seats required. No loss of control.
• No valuation of the business is necessary.

Some potential downsides of RBF are:

• It is more expensive than most other forms of non-equity funding.
• It can become a trap if the company’s revenues stop growing at the trajectory necessary to pay off the investment + cap in the projected timeframe. In this scenario, most agreements provide for the periodic increase in the % of revenue going to repayment which could starve investment in R&D and sales & marketing necessary to reaccelerate revenues. It can also result in a large balloon payment at maturity which might only be able to be paid if highly dilutive capital is raised for that purpose.

Your vcfo consulting CFO has the expertise to prepare 3 – 5 year financial models that show the anticipated funding requirements and timing of your funding rounds. This data can be integrated with your cap table data to calculate the anticipated dilution impact of each round of funding. Solutions incorporating alternatives such as venture debt or RBF can be compared to come up with an optimum funding plan.

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vcfo is a professional services firm making companies stronger by bringing the wisdom and experience of senior level Finance, HR, and Recruiting executives to each client engagement. Our team of consultants guides CEOs and business owners in making strategic decisions, optimizing operations, and providing people support. Partner with the vcfo team to identify various funding alternatives available to fund your business plan. Remember – nothing is more valuable than your equity. Take great caution in agreeing to any dilutive commitments.

Since 1996, vcfo has supported more than 5000 clients nationwide with offices in Austin, Dallas, Denver, and Houston.