The roots of software-as-a-service (SaaS) companies date back to the 1990s, and since that time, tens of thousands of SaaS businesses have entered the market. Up until recently, funding options for new SaaS startups revolved around simply using generated revenue to grow or trading part ownership of the company to investors for capital.
In recent years, more non-dilutive funding options have entered the picture, providing often much-needed financing to SaaS start-ups without requiring equity in the company itself. This guide will provide some industry background, explain the difference between dilutive funding and non-dilutive funding, and share a comprehensive list of funding categories.
Rapid Growth of SaaS
When SaaS platforms began making software available to customers over the internet, they completely changed the pace of technology adoption. A lengthy implementation process quickly shrunk to download time, and IT departments had to make the switch from managing physical technology assets to handling cloud-based challenges.
Since most SaaS models generated revenue from a tiered subscription agreement, the potential for rapid scaling existed, which again, increased the pace of growth for SaaS companies. Items such as security, maintenance, and compliance were often rolled into the SaaS offerings.
For new players entering the SaaS market, the rate of growth had to match the expectations of the industry, often requiring significant capital during the early stages. For most startups, that meant relying on venture capital (VC) funds or other equity financing that required sacrificing a percentage of company ownership.
The Difference Between Dilutive and Non-Dilutive Funding
The main difference between dilutive and non-dilutive funding for SaaS companies has to do with how much ownership, control, and future returns an entrepreneur is willing to sacrifice for the capital. VC funds also come with an expectation that the founder is willing to “go for broke” and either achieve a billion dollar outcome or die trying.
Dilutive funding, otherwise known as equity financing, requires trading capital for a percentage of ownership, some level of management control, and a portion of future profits. VCs are less concerned about earning traditional returns based on profit sharing and more interested in rapid growth, which often leads to the need for more VC funds.
As a founder, it’s important to remember that the types of outcomes a VC considers “good” is quite narrow relative to a “good” outcome for you and your personal wealth. VC is structured for $0 or $1B+ outcomes, but for founders there are many life changing outcomes in between.
Non-dilutive funding, on the other hand, includes ways to attract capital without sacrificing partial ownership or control of the company. Many types of non-dilutive funding for SaaS companies exist including government tax credits and grants, crowdfunding campaigns, and private financing. Each offers advantages and disadvantages, and may be suited for particular types of growth and expansion.
The Long-Term Consequences of Dilution
SaaS companies opting for dilutive funding should understand that venture capitalists, angel investors, and other equity investors often tuck extra stipulations and requirements into the details of funding agreements. Over time, some of these provisions can have a significant long-term effect on a company’s revenue, control, or growth.
According to Dries Buytaert, an open-source advocate and technology executive, five factors have significant dilutive effects on SaaS companies. Buytaert discusses, in detail, the dilutive effects of multiple rounds of funding, reverse vesting, option pools, pro-rata rights, and liquidation preferences. Here’s a quick summary:
- Multiple Funding Rounds. With each round of funding designed to take a company to the next level of growth, founders will probably be forced to give up an added percentage of their business. Ideally, Buytaert suggests a maximum sacrifice of 25% dilution during the first round, which would decrease by 5% in each subsequent round. Even at this rate, four rounds of financing will leave entrepreneurs with only 30% of their company.
- Option Pools. Unfortunately, relinquishing a percentage of a company is not the only dilution factor. Most investors will require that an employee option pool is also created, which shifts between 10% and 20% of new value of the company from the founders’ equity into a fund for future employees.
- Reverse Vesting. To ensure that founders stay with the company, investors frequently want the right to repurchase the founders’ shares of the company if they choose to leave. The vesting period is typically four years; at that point, founders usually can keep all their initial shares.
- Pro-Rata Rights. Through multiple rounds of non-dilutive funding for SaaS companies, early investors and new investors begin negotiating ownership rights. Initial investors often want pro-rata rights, or the right to invest in future rounds to grow their investment with the company. New investors, however, want their fair share of the company as well. The demands from multiple investors often force founders into even greater dilution.
- Liquidation Preferences. Finally, investors often require a liquidation preference to protect themselves against companies that fail. This preference means that investors will be allowed to liquidate their stock before other shareholders. In some cases, investors require “participation rights,” which allows them to take out their initial investment (or even multiples of that investment) as well as the value of their stock.
After four rounds of funding, many company founders end up with single digit percentages of ownership. For example, Aaron Levie, founder of enterprise cloud company Box, owned roughly 4% of his company at the time of its public offering. When Zendesk went public in 2014, owner Mikkel Svane owned about 8%, and a co-founder of ExactTarget owned just under 4% when the company filed its S-1.
If SaaS companies do not make it to the public offering level, founders can be left with even less after adjusting for risk, opportunity cost, legal fees, and other factors. It’s important to remember that reduced equity can mean loss of control, decision-making power, and future spending choices in addition to fewer long-term returns.
Types of Non-Dilutive Funding
As demand for funding new SaaS companies continues to increase, more organizations are developing creative ways to provide capital. As a result, the types of non-dilutive funding options are already wide and varied with other potential creative funding solutions on the horizon.
Understanding how each type of non-dilutive funding works as well as what type of situation it is designed for can help owners of SaaS companies make better decisions each time they need to secure capital for growth.
Current categories of non-dilutive funding include government grants, crowdfunding, public tax credits, government voucher systems, private loans, revenue sharing, and venture debt.
Banks, financial institutions, and other lending organizations are anxious to help fund new or growing SaaS companies. According to Gartner, revenue from SaaS businesses around the globe is projected to exceed $151 billion by 2022. Many of the tens of thousands of private SaaS companies are still in the early stages of development as the global business market transitions from on-premise-based software to cloud-based solutions.
More and more banks and lending institutions are entering the market, expanding the loan options for SaaS companies, which have had limited asset-based loan options from only organizations specializing in SaaS loans. Interest rates and repayment terms are expected to evolve, generating a greater number of creative loan options for SaaS companies seeking funding.
Revenue-based financing provides non-dilutive funding for SaaS companies by offering capital in exchange for a fixed percentage of the company’s gross revenue until the loan amount plus a negotiated multiple is reached.
This allows SaaS companies to repay loans at the same rate that it is generating revenue, reducing the risk of needing to dip into operating cash to meet loan obligations. Typically, gross revenue is either calculated daily or monthly to determine repayment amounts, and loans are expected to be repaid within three to five years.
Venture Debt Financing
For those SaaS companies that do not have positive cash flows or enough assets for loan collateral, venture debt financing may be an option. In this case, these specialized lending organizations provide capital loans that are tied to warrants, which gives them a right to buy equity in the company at a set amount. This helps offset the risk that venture debt lenders take in funding these SaaS businesses but also minimizes dilution for the owners and other investors.
Government-based economic development programs at both the state and federal level exist to encourage the growth of domestic-based businesses and can be a good source of capital for new SaaS companies. However, they can be extremely competitive so it’s important to have a clear business model and sound plan before applying.
At the federal level, the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs “enable small businesses to explore their technological potential and provide the incentive to profit from its commercialization.” Entrepreneurs need to progress through either two distinct phases or one fast-track phase, which includes establishing their worthiness for a grant through an outline of research and development projections and/or results, business performance to date, and commercial potential. Grants range from more than $200,000 to well over $1.5 million of the course of six months to two years.
Individual state economic development programs may also offer grants, which can be less competitive but somewhat more difficult to find due to year-to-year funding changes. They can also be varied as to how they accept capital requests and award financing.
For example, programs like the Arizona Innovation Challenge creates competition for funds while the Colorado Proof of Concept grant focuses on connecting research institutions to private commercialization opportunities. Although some state grants are focused on increasing exports or employee skills development, many others are designed specifically for the technological innovations that are well-suited to SaaS companies.
Although the idea of crowdfunding can date back to the 1700 Irish loan funds, the first modern-day crowdfunding effort is recognized as a fan-funded reunion tour by a British rock band. Since then, companies such as Prosper, Kiva, Kickstarter, Indiegogo, and others have paved the way for non-dilutive funding for SaaS companies.
According to an article in Startups Investing, businesses seeking to secure crowdfunding capital today may do well by entering a partnership with a marketing agency that specializes in maximizing crowdfunding participation.
Since both state and federal governments have a vested interest in helping companies like SaaS businesses succeed to not only provide future tax income but also domestic employment opportunities, they provide various tax credit programs to encourage and support investors.
The Tax Credit Finance Resource Center, created by the Council of Development Finance Agencies, offers comprehensive information about tax credit programs as well as how they can be applied to a SaaS business. Tax credits decrease an investor’s tax liability. At the federal level, a New Markets tax credit program is available while many others dedicated to technology development can be found at the state level.
Investors need to show that an actual investment has been made in things such as a physical building or cash outlay. Credits can then be used to boost the rate of return internally, decrease interest rates in a specific round of financing, or establish a non-cash investor repayment option.
Government vouchers are another source of non-dilutive funding for SaaS companies, which can be used to pay for products, services, access to facilities, or consulting advice from other businesses. Although vouchers don’t carry an actual cash value and cannot be transferred, they do allow SaaS businesses to either receive products or services at reduced or no charge to them. Some vouchers can be used to secure specific types of unsecured loans as well.
Below are some financial institutions that provide non-dilutive funding loans for SaaS companies.
TIMIA Capital offers a Springboard loan that is designed to help SaaS businesses obtain enough cash to meet final goals. Typical companies will have $3 million more in ARR as well as average cash burn.
Triple Point Capital
Triple Point Capital provides a wide array of debt financing solutions ranging from $10,000 to $100 million. This lender offers both asset-based financing for things like equipment acquisition or accumulating inventory as well as purpose-based financing that includes runaway extensions or buy-outs.
Capital bills itself as an intelligent credit market for SaaS companies and other businesses. SaaS companies are asked to upload their financials into the system, allowing Capital to identify the aspects of a business that are financeable without dilution. The provider then creates a custom financing plan, outlining the risks and benefits of each option, and gives the SaaS company an opportunity to select options that seem best for their current needs.
Revenue Based Financing
Here are organizations that offer revenue-based non-dilutive funding for SaaS companies.
SaaS companies who receive payments on Stripe may be eligible for Stripe Capital funding options. Those U.S. businesses who have at least a one-year history of receiving Stripe payments may be eligible. Those businesses that take advantage of this non-dilutive funding for SaaS companies will automatically repay the loans through a percentage of Stripe sales. A minimum payment is required.
Specializing in SaaS funding, Element professionals take a more personalized approach. After an initial call, Element will collaborate with the SaaS to determine terms before preparing the necessary paperwork and dispersing the funds.
TIMIA Capital also offers Revenue Financing loans that can be used to pay for sales and marketing, acquire other organizations, or liquidate other investors. In this case, TIMIA Capital will consider the specific metrics of a SaaS company and create risk-adjusted terms.
While revenue-based financing provides growth capital, factoring financing provides working capital. Here are some lender options.
Pipe boasts a rapid application process, making current revenue streams tradeable for loans up to their annual value. SaaS companies requiring greater cash flow may find scaling up easier with these non-dilutive funding options.
Capchase is also a factoring capital provider, allowing SaaS companies to draw the annual value of their recurring revenue stream as a cash loan. They specialize in subscription-based companies such as SaaS.
By converting current subscription-based customers into collateral, SaaS companies can obtain the cash they need now to further their growth. Founderpath provides that factoring capital option.
Cautions in Non-Dilutive Funding Options
As with all funding options, some non-dilutive funding options may have some potential disadvantages for certain companies. Here are some cautions to keep in mind:
Warrants can be a required condition of a non-dilutive loan, which would automatically allow a lender the right to purchase a certain amount of a SaaS company’s stock up to a preset deadline. Most warrant requirements fall in the 5% to 10% range. If a company secures a $1 million loan with a requirement to provide warrant coverage at 10%, a SaaS business would give the lender the right to purchase $100,000 worth of company stock.
Although a non-dilutive lender may not get immediate equity in a business, warrants allow these lenders to have the option to buy into the company at a later date, which would result in dilution.
Covenant requirements specify minimum levels of either performance or revenue in order to maintain the non-dilutive loan conditions. Some loan organizations will require covenants as a way to reduce their risk and ensure that the SaaS is making reasonable progress in growing its company.
An example of a covenant may include an agreement to secure a certain number of new customers each month while retaining a certain percentage of existing customers. If a SaaS company fails to meet the terms of a covenant, its leadership may be required to actively find solutions with the lender. However, if the issue is not resolved, the borrowing business may be subject to higher interest rates or be unable to secure additional credit. In the worst-case scenario, tripping a covenant could result in immediate demand for repayment of the loan, which could result in bankruptcy.
The final stipulation that SaaS businesses may be asked to consider is the personal guarantee, which requires the founders to be personally responsible for the debt taken on by a business. This obviously puts individuals at risk, and companies need to weigh the benefits vs disadvantages in such an agreement.
In seeking non-dilutive funding for SaaS companies, it’s important for businesses to note regional differences. Government regulations in specific countries may dictate how and where the money may be used.
In addition, SaaS businesses may be able to find grants and other local sources of funding in specific cities and countries, especially if they contribute to the local economy. Be sure to consider not only where extra non-dilutive funding may be available but also any geographical limitations in its usage.
The application process may vary a bit depending on the lender but here are the basic steps:
- SaaS businesses should contact their lender of choice and arrange for an initial consultation.
- Complete a lender-initiated questionnaire, which will typically ask for basic information such as recurring revenue over the past three, six, or 12 months, cash burn, outstanding debt, gross margin percentage, and other similar data.
- Once the lender evaluates the SaaS company’s responses, it will typically purpose terms, structure, and pricing information accordingly.
- If all progresses to this stage, the lender will conduct its due diligence process to validate all data, which is followed by a lender meeting to review and finalize details.
- The legal department completes the final steps by drawing up necessary documents and agreements, which are then circulated, signed, and approved to close the deal.
Let Paper Do the Legwork
SaaS businesses are busy trying to grow their companies. Those seeking non-dilutive funding for SaaS companies can rely on Paper to eliminate noise in the funding process. As a capital marketplace for SaaS companies, Paper allows SaaS organizations to apply to dozens of capital providers with a single click.
SaaS companies are invited to enter business-specific metrics, acceptable options, desired loan amount, and other information. Paper will then automate the application process by matching SaaS companies with multiple lenders and completing all the required paperwork in an instant.