How is debt good for a SaaS company?
The general belief is that SaaS companies have really high margins. Some sources put the average SaaS gross margin as high as 90%. While some companies may be able to run their business with that high of a margin there are plenty of well-known SaaS companies who have not done as well.
Sammy Abdullah, of Blossom Street Ventures, published an article on LinkedIn back in May of 2021 where he evaluated the margins of forty-two different publicly-traded SaaS solutions, with at least $180MM in median revenue. Can you guess what the median operating margin was of those companies? Lower. Nope, lower. If your guess is below zero you are a winner in my book. Those companies had a median operating margin of -21%. Sure, some of the companies represented are still in a growth phase where they are spending a lot of capital in order to scale. But, even the average operating profit for profitable companies wasn’t anything to get overly excited about. It was 14%.
So, what does that have to do with your SaaS business? Well, if you are experiencing similar pressure on your margins and/or you are trying to scale your business you are going to need some capital to accomplish your goals. There you have two choices – equity or debt. Let’s take a look at why debt might be your best option. As well as why it may not be.
Using debt to scale your SaaS business
Leveraging debt can offer a couple of benefits for the right company.
First off, with debt, as opposed to equity, you aren’t having to give up shares in your company in order to attract capital. Some founders struggle with giving up ownership in their business. Whether because they are emotionally tied to the business or just not willing to give up some of the business’s future value.
Secondly, lenders won’t get involved in the day-to-day operations of your business. The same can’t always be said for equity investors. Especially when those equity investors have demanded seats on your Board of Directors.
Debt might be particularly attractive to you right now because rates are pretty low. Perhaps not as low as they were during the pandemic. But rates on business loans tend to follow certain indices, such as the Prime Rate. It has been at 3.25% for some time now. In fact, the last time the Prime Rate was that low was 1955. The record high was 21.5% in 1980.
One last benefit of using debt is that you start to establish credit for your business. Most people are aware that they have a personal credit score. But fewer understand that your business also has a business credit score that includes your performance with other lenders and suppliers. Even if you only borrow a small amount of money for your business, establishing a business credit profile is important because it will make borrowing large sums of money easier in the future.
When debt may not be right for your SaaS business
On the other hand, debt may not be right for use in scaling your business if the following things concern you.
Whereas most equity investments don’t require regular payments to be made, with debt you will have to make recurring payments. Generally speaking, the frequency of those payments will be monthly. If you have a cyclical business then making a payment during your down months can be tough if you aren’t good at planning and setting aside revenue from the good months to cover those payments.
Some lenders require the owners of the business to sign a personal guarantee. This means if the business isn’t able to make the payments then the lender can ask the owners to make the payment. If that is a concern for you then debt may not be the right option for your business. In that case, venture capital may be the better option. One way to think about personal guarantees is that it is like asking the owner to stand behind their business. After all, if a lender is going to support the business with capital then why shouldn’t the owners support the business with their name?
Finally, you may be required to provide collateral to secure the loan. For example, a bank may use a UCC filing (that’s a fancy word for a lien) to collateralize the loan.
The Benefits of Debt without the Negatives
It is possible to experience the benefits of leveraging debt, such as affordable rates, without many of its traditional challenges.
Our Recurring Revenue product was specifically designed for companies such as SaaS businesses that have subscription-based revenue models and are looking to borrow money against their MRR (monthly recurring revenue). With this type of financing your already established recurring revenue acts as your collateral.