I'm not a SaaS company: How do I finance my growth?
7 minutes read
With their easily scalable model and recurring revenue, SaaS companies have access to a variety of funding options. Venture capital funds and angel investors are very willing to invest in early SaaS companies. And entrepreneurs who want to avoid diluting their ownership have been able to work with a growing number of lenders, including BDC, even if they haven’t yet achieved profitability.
But with so much energy and attention being given to SaaS companies, access to growth capital isn’t as easy to find for dynamic, non-SaaS tech companies. These businesses are often misunderstood by lenders who find it difficult to understand their business model. Meanwhile, equity partners often aren’t as interested in businesses that take longer to scale.
While many fast-growing non-SaaS companies are IT service companies, others included in this category are traditional software companies, e-commerce companies, tech-enabled service companies and content producers.
Many technology companies, both SaaS and non-SaaS, have benefited from the changes brought on by the COVID pandemic. Industries have been accelerating their digital transformation, consumers are now more likely to engage with e-commerce and technology needs to facilitate remote work and learning have increased. These trends have created are positive tailwinds for Canada’s tech sector.
With positive prospects for the foreseeable future, how can non-SaaS tech entrepreneurs access the financing they need to grow? We hope to help answer that question in the rest of this post.
SaaS vs. Non-SaaS: How the models differ
SaaS companies will often invest large amounts upfront to develop their product and market it to customers. Once their software is built, these companies can easily scale up—it cost almost nothing for a SaaS business to add a new customer.
Further, because there are so many SaaS companies, the industry has developed metrics that can be used to compare one business to the other and to understand their performance.
Meanwhile, Non-SaaS tech companies come in a variety of shapes and forms. About the only thing they all have in common is that their revenue isn’t recurring. To start working with them, lenders and investors need to work with entrepreneurs to understand their business model.
E-commerce companies, for example, are unique as tech companies go in that they have inventory that needs to be paid upfront, which can create cash flow challenges. And while they do not have to carry accounts receivable—since they are paid right away when a sale is made online—banks will often refuse to provide them a line of credit because they cannot take their account receivables as collateral.
At the same time, the metrics used by e-commerce companies are by now well understood and codified. Repeat order rates, customer acquisition costs and other performance measures across the customer journey can be used to compare the efficacy of e-commerce companies in much the same way as it is done for SaaS companies.
Non-SaaS software companies tend to face another set of problems. These companies often sell large, complex systems such as ERP software with sales cycles that resemble large equipment purchases. Cash inflows are very lumpy, with a small part of the sales price being made up of implementation and recuring maintenance costs. The challenge for us is in being able to understand how the business will scale.
A closer look at tech service companies
IT service companies are a particular type of non-SaaS company. Compared to software companies, most IT service companies require less upfront investment. They’re also profitable earlier in their lifecycle.
However, IT services are much more labour intensive than SaaS companies. In order to scale up, service companies need to grow their team; they need to hire more people and train them so they can start providing value for customers. The challenge is to get the right balance between revenue levels and the right-sized bench. Do you hire at a loss before getting a contract? Or, do you accept a contract hoping you’ll be able to hire after signing the deal?
With industry growth outpacing the rate of new tech graduations in Canada, we’ve helped several IT service companies make acquisitions to grow their team in the past year or so. Yet maintaining the right bench strength when making an acquisition can be hard. New team members need to be trained and integrated, imbalances are common, and it can take time for the acquisition to pay off. To succeed, businesses need access to patient capital that will be flexible enough to give them time to work through the challenges of an acquisition.
Service companies tend to be most profitable when they reach certain plateaus, something we don’t see as much with SaaS companies
Professionalizing a service company can also be difficult. Some of the most profitable non-SaaS businesses we see are highly specialized service companies with 20 or less employees. These businesses can operate with a very low cost-base since they don’t need a management team and almost every employee is working on billable hours.
To grow beyond that point, entrepreneurs have to hire professional managers. But it can take time for the company to get a return on that investment. Because of this, service companies tend to be most profitable when they reach certain plateaus, something we don’t see as much with SaaS companies.
Customized financing for non-SaaS companies
The particularities of their business model make it harder for many growing non-SaaS tech companies to obtain financing.
Traditional debt financing remains an option for cash flow positive companies, but since businesses will often put additional pressure on their cash flow as they build up their team or acquire new customers, debt financing will either be limited or it will put undue pressure on their cash flow.
In these cases, mezzanine financing becomes a very attractive option. A hybrid of debt and equity, mezzanine shares some of the characteristics of debt financing because the borrower has the obligation to repay. On the other hand, it also resembles equity financing because repayment is based on cash flow rather than depreciating company assets.
This allows a company to tailor repayments according to its needs. A company could choose to only pay interest until the loan matures and the principal is repaid with a balloon payment, for example.
Non-SaaS companies need to be valued differently
Most financial institutions value a company exclusively on past performance. Since a company’s value is based on past EBITDA results, unprofitable companies and companies that are reinvesting in their growth are often cut off from the funds they need to expand.
To get around this issue, we often work with tech entrepreneurs to value their company using valuations methods that are consistent with their industry. An e-commerce company may be valued using a multiple of revenue, for example. In the case of a specialized tech company with significant goodwill or intellectual property, forecasted sales might be used instead of an EBITDA multiple.
This can often result in higher valuations for the borrowing company, allowing us to unlock additional financing that businesses can use to grow or make acquisitions.
Let’s take for example a company with an EBITDA of $300,000. Assuming an EBITDA multiplier of 5x, the company would be valued at $1,300,000.
Meanwhile, valuing the same business based on expected future cashflow with an estimated growth rate of 15% gives an equity value of $1,834,000.Enlarge the table
Companies need breathing room to grow
Our experience has shown that non-SaaS companies often need additional flexibility when trying to grow.
By working with partners who understand their business model and take the time to meet their team, tech service companies can access patient, customized capital that will allow them to scale up and create world-class companies.
If you think we could help you grow, don’t hesitate to get in touch.