Why SaaS business model may be the best choice for tech startups

Mike-Warner-Fall-2015-200x300Today’s guest post comes from Mike Warner. Warner has had a 40 year career spanning a broad spectrum of business startups and expansions. They range from food processing to software to pharmaceutical imports and our region’s major hospital/clinic complex. The companies include American Crystal Sugar, Progold, Dakota Growers Pasta, Spring Wheat Bakers, Meritcare (now Sanford) and Agriceutical Resources. His most recent efforts included working with his son, Alex Warner, to establish Pedigree Technologies, a software company focused on “Machine to Machine (M2M)” communications and data management.

Mike currently serves as the Treasurer and Finance Committee chairman of the Dakota Medical Foundation, with over $100 Million in assets, and is a board member on the North Dakota State Board of Higher Education Foundation. During his career, he has helped start, direct and expand companies totaling over $1.5 Billion in annual sales and an equal amount in assets, and he has helped plan and execute the capitalization of start-up businesses ranging from less than $1 Million to over $250 Million.

It is a combination of this background and his contribution to the now 13 year old Pedigree Technologies, which has prompted him to generate the following “Q & A” article. The article addresses one, of what he believes, may be the most effective forms of early financing of technology companies, which use the “Software as a Service” business model.

1. How does the “Software as a Service (SaaS)” Business Model work?

Software as a Service, which is often referred to as SaaS, provides customers access to software over the internet. Rather than installing the software on the customer’s computer, the customer simply goes to a secure website and uses the software available there. Usually the software has been tailored to their businesses, and they access and use it on the internet. They pay a monthly fee.

(Check out this list of top 10 successful SaaS companies you may know, including Salesforce and LinkedIn.)

2. Why do customers want to use the SaaS Model?

There are several reasons, but there are two major reasons customers will use this business model.

  1. There is a significantly lower up-front capital expense than the outright purchase of software. Rather than making a large up-front investment in software, they simply agree to a contract which binds them to the services for a period of time, and the customer makes monthly payments.
  2. Second, it eliminates the need to purchase and install “The New Version” of upgraded and improved software on customer computers. Because the software is actually located on a secure site on the internet; upgrades, improvements and additional services are being added all the time. Customers access them immediately by simply engaging more services over the internet.

3. Is the “Software as a Service” business model, widely accepted and used?

Yes, and it is rapidly growing. With the expansion of “SMART” devices such as smart phones and tablets, people are more and more wanting access to software services over the internet. They want this rather than purchase and download software to fully operational computers and computer networks, which are less convenient and versatile than the smart devices.

As also mentioned a big reason is it makes it possible for the software companies to make constant improvements, upgrades and add additional serviced quickly and easily to customers. Many of the improvements aren’t even known to the customer. Companies also like it because it makes it easy and rather inexpensive for the customer to purchase the software, which in turn helps to accelerate sales.

4. Are there unique issues or problems associated with the SaaS business model. What might these be?

The SaaS business model is primarily a way of financing the customer’s purchase of their software. Rather than paying all software expense up-front, the customer is allowed to pay for the software over time with much smaller payments. However, like the telephone bill, you never really do get finished paying for the software.

However, this “customer financing” results in the software company having to wait months or even years to get the full cash flow benefit of their customer sales. The traditional software companies get full payment up-front, which provides much more immediate capital for company operations. So, SaaS companies often operate with a high demand for cash, but limited sources to access it. This is especially so in the start-up and early growth phase of the business.

5. Can’t SaaS companies find financing to finance their development and operations?

Yes, but it comes at a cost. In general, startup software companies have large up-front development costs, which can go on for years while generating little or no revenue. Early on equity financing tends to be the only source of capital for the startup software company. Software companies are often started by entrepreneurs who have very limited access to capital. So they almost immediately start out selling part of their companies just to develop the software product.

6. You say “equity financing” is the only source of early company finance. Is there not some form of debt financing which might be available?

No, in the start-up and early growth phase of a software business, debt financing with traditional sources such as banks is almost non-existent. The primary reasons are the lack of sufficient revenue and the lack of “hard asset” collateral. Software is not a hard asset like a building or equipment, and does not qualify well for collateral for a loan.

Also, even though SaaS companies are selling 1 to 3 year contracts consisting of monthly reoccurring revenue (MRR) each month, generally accepted accounting principles (GAAP) only allows the revenue for each month to be counted in the profit and loss statement. So, while SaaS companies are piling up valuable contracts, their GAAP reported P&L statements make the company appear to be losing money. This further exasperates chances of traditional debt financing. One of the region’s SaaS companies is close to GAAP breakeven. They project at that time they will have in excess of $10 Million in contracted revenue yet to be received from their customers. If they were being paid in full for their software up-front, they would have been GAAP profitable long ago.

Thus, the startup company is driven to equity financing. Equity financing continues until a time when the software company can demonstrate a continuous and reasonably reliable revenue flow. Eventually, specialized debt financing will give value to the established history of revenue flow and finance the company’s needs. However, it is often expensive and it may be years before this is available. All the time equity financing is taking over ownership of the company, and the founder’s ownership is being diluted.

7. If equity financing is the only major source of early financing for startup and early growth software companies, is this really so bad?

There are several negatives associated with Equity Financing, especially in our region. First, the amount of capital needed to launch a viable software company with a chance to reach and compete in national markets and reach successful cash flow is estimated to be between $15 million to $20 million. Our region has very limited access to this level of risk financing, which tends to drive the company toward outside sources of capital. These sources are often aggressive, expensive and have business goals not necessarily aligned with establishing a software company in our region.

If this capital can be attracted, it is usually because the company’s business plan and products are viewed as having a good chance at success. This is the fruit work and planning of the founders and early investors. Yet, with this outside financing, the founders and early investor’s ownership, influence and control over the company become reduced and diluted. The risk increases that the company may be sold or merged with companies outside of the region, and even may be moved to another location outside the region.

8. So, if your assumption is correct it would seem that some sort of alternative to outside equity financing for startup and early growth SaaS companies would be more likely to keep ownership and location in our region. Does such alternative financing exist?

Yes, once a SaaS company begins to sell its products and services to customers, they have contracts which bind the customer to purchasing services for a period of time. As an example, a contract to pay $1,000 per month for SaaS services for 3 years is a contract with total revenue of $36,000 dollars over the next three years. Specialized financing sources called “Contract Equity Lenders” are aware of these contracts. These “Contract Equity Lenders” will borrow on this monthly reoccurring revenue stream, in our example of $36,000 over 3 years, from the SaaS company for up-front cash but at a discount well below the future cash stream value of $36,000. They usually run credit checks on the contracted customer to make sure they are capable and have a history of paying on time and in full. If the software company’s customer meets credit criteria, these financing sources take over the revenue stream from the customer.

9. Well, it seems there are alternatives to equity financing for SaaS companies provided by these “Contract Equity Lenders”. Are there problems or limitations connected with selling SaaS customer contracts to these specialized “Contract Equity Lenders”?

Yes, they tend to purchase contracts late into the early growth stage of a company or even in the next stage of the business evolution often referred to as simply “growth”. So, they show up a little late of the scene to help the founder and early investor avoid dilution and loss of control associated with outside equity. They also tend to discount the contracts rather heavily. Theydiscount the revenue stream and then pay cash at the discounted level. So, at a time when acompany in growth is trying to preserve cash to finance the growth, a significant portion of the company’s future revenue is being paid to the “Contract Equity Lenders”.

In Conclusion…

Software companies have significant upfront costs, which can span years. In many if not most cases, the only source of financing will be the sale of equity. By the time the company is stable and viable, it is highly likely the founders and early investors, which wanted the company to stay and grow in our region, will no longer have control. Control will likely be in the hands of outside sources of equity, which may not share an interest in the growth of our regions technology business sector.

I have come to the conclusion, there are great opportunities for our entrepreneurs, financing community and the economic development of our region. However, we must be willing to embrace and understand how contract equity financing works in the SaaS business model and then make use of it. A careful and deep review of this financing method will show a combination of three important elements will greatly reduce the risk.

1. Limiting Contracts Used – The approach to the amount of contracts financed is limited to only a portion of monthly sales, which leaves the remaining contracts to accumulate as a source of future revenue and a growing company asset.

2. Customer Provides Additional Security – Because SaaS is really a means of financing the customer purchase of the software, the customer’s financial strength also guarantees financing sources will get paid, as well as the guarantee of the SaaS company itself.

3. Software Has Larger Gross Margins – A lot of time is consumed between the start of software development and the time sales start in earnest. As a result, the gross margins tend to be fairly high as a means of re-capturing the development costs. This means there is significant room for higher costs than the going rate of traditional operating loan interest rates.

The SaaS business model is expanding and quickly becoming the most accepted way of providing software and associated technologies. This type of financing is done all the time for the reasons mentioned, but it tends to be late and expensive. If we can devise ways to provide this financing sooner and less expensive to our entrepreneurs and technology start-ups, we will retain more homegrown companies and attract others to our region. Years ago South Dakota had the foresight to create the best atmosphere possible for the Credit Card industry, and reaped great benefits. A similar opportunity in attracting SaaS businesses to our region exists, if we have the foresight and willingness to do the same.

Marisa Jackels

Marisa Jackels

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