When MemSQL announced last month it had raised $50 million, the announcement was notable because the money was in the form of debt, not equity. For a software-as-a-service (SaaS) start-up such as MemSQL, whose real-time database system is used by major banks and other companies relying on fast data analysis, the typical path to capital is through equity raises. But venture capital specialists say they're seeing a trend in which more SaaS start-ups are turning to debt as a tactical option because it enables them to grow without having to hand over control to equity partners.
"What's disruptive is not that there's debt," says Jason Lemkin, a venture capitalist and founder of several tech firms. "Debt has always been available to a select few. It's that bootstrap folks can get it."
MemSQL is hardly a bootstrap company. It was founded in 2014 and, with its fast growth (200% in 2018), it's had little trouble attracting big names in venture capital, including Y-Combinator, Accel, and Data Collective. Just before the pandemic hit, it had planned to go out with a capital raise and had more than half a dozen funds interested in investing, but it opted for debt instead; the company was in a good cash position, CEO Raj Verma told TechCrunch, so it didn't need to give an equity position to investors.
“Our cash burn is in the single digits,” he said. "And we still have independence."
New debt options
Silicon Valley Bank (SVB), among other venture-backed lenders, has long been in the debt business for start-up SaaS businesses, but its capital is tied to a venture capital firm, and it makes decisions in part based on who the equity capital partners are in the start-up, Lemkin said in an Extra Cunch podcast in March.
"SVB will go in and say, 'Who's on your cap table?'" said Lemkin, founder of cloud-based e-signature company Echosign (now part of Adobe). "They'll call the partner up, and say, 'What are the odds you're going to write a bridge check?' So, at least SVB knows the odds you’re going to write a bridge check."
Lemkin credits lenders like Lighter Capital, founded in 2010, and Clearbank, founded in 2015, for giving a debt option to SaaS start-ups that don't come with a Silicon Valley pedigree.
"There's 50 times more availability of [debt financing]," he said. "As there should be, because there are 50 times as many good SaaS companies."
Salesforce.com is considered a key reason lenders are willing to underwrite loans against a SaaS company. The company, launched in 1999, is credited with showing investors and lenders the subscription model not only can go toe-to-toe with on-premises software companies but can even beat them.
Today, SaaS is an established business model in tech and there's a big set of metrics — annual recurring revenue (ARR), lifetime customer value (LTV), churn, for example — that investors and lenders are using to gauge company health. That gives lenders the performance measures they need to underwrite loans, and analysts say debt is poised to become a bigger part of the mix.
"This standardization of SaaS as a business model is why we’re seeing more debt deals in business headlines today," says Nathan Latka, principal of Latka Capital and host of a podcast on entrepreneurialism.
Because of the rise of SaaS companies, Latka says, especially in crowded spaces like CRM and sales automation, it’s becoming harder for venture capital firms to get the return they need to make big bets on promising start-ups. But for lenders, who only expect 5-6% returns, as opposed to the 40% returns VC firms expect, underwriting little-known start-ups can make sense.
If, for example, a company can show its churn is under 10% annually, has 110% net revenue retention and gross margins of 85%, among other performance milestones, it can be a good candidate for a loan, Latka says.
"These metrics de-risk the business, allowing founders to build wealth, while building their idea on the back of cheap production capital in the form of debt," he says in a Saas Brief blog post.
But debt comes with risk. Lemkin advises start-ups to use debt as a tactical tool. Instead of taking out a loan for $20 million and hiring 40 people, take out $2 million and use it to make a key hire that you otherwise would have to wait to get. But then get back to a net cash position as soon as you can.
"You shouldn't spend it like equity," he says. "You should spend it to make that extra hire this week, but your net cash probably should stay the same."
Although debt doesn't come with the shared control that's part of an equity deal, it comes with terms and warrants, underscoring the need to treat it as a tactical tool.
"If you raise it and don't spend it on a net basis, you'll get all the benefits of SaaS [without] the downside of running that gas tank empty," Lemkin said.
For many SaaS founders, debt remains something of an unknown, but that might be changing.
"Many SaaS founders don't understand how debt works," Latka said. But as more companies follow MemSQL’s lead, taking out debt instead of going out with a new capital raise, the education gap will close and new opportunities will open up.