RISKY BUSINESS

Cash-strapped startups are turning to a funding tactic used by oil and gas companies in the 1900s

Software-as-service companies have a great business model. Instead of one-off payments for software, these companies charge subscriptions, monthly or annual payments for delivering software through the browser. It gives them a predictable, ongoing stream of payments with plenty of room for lucrative upgrades. No wonder SaaS businesses are on track to grow five times faster than traditional software firms, reports market research firm IDC.

Yet financing options for such businesses are virtually unchanged. Most early-stage companies face the unpalatable choice of trading big ownerships stakes for venture capital, or securing a loan from banks who regard most startups as black holes of unsecured risk. Many companies then stay undercapitalized and slow-growing as they claw their way to scale.

To get growth capital, startups are turning to a technique pioneered by oil and gas barons in the early 1900s: revenue-based lending. Although employed by the music, movie, publishing, and pharmaceutical industries, it has only recently found a natural fit in the SaaS model.

The principle is simple. SaaS companies generate fairly predictable streams of monthly payments. Financiers can lend against this future revenue stream despite the lack of assets.

This money comes at a cost considerably higher than that charged on traditional loans secured by assets. Interest rates are typically around 15% to 30% higher than those charged by banks. Companies can typically repay the loan as a percentage of cash flow so payments naturally adjust to revenue, and the total repayment is capped at about twice the amount borrowed over five years. For startups, the higher interest charges are worth not having to issue equity to investors.

“We’re operating in a piece of the market that bigger banks have not played in: cash-burning, fast-growing, entrepreneurial business,” says Zack Mansfield, a managing director at Square 1, a division of Pacific Western Bank, which offers revenue-based loans to startups. “We’re trying to fill that financing gap.”

Seattle-based Lighter Capital, another active player in the market, has lent $35 million to 108 companies since 2010, and is reporting exponential growth this year. The firm made more loans in August than all of 2013.

Most of LighterCapital’s portfolio companies have little outside investment, and only 20% end up taking venture capital, says BJ Lackland, LighterCapital’s CEO. Lighter Capital’s funds are backed by Community Investment Management, an impact investment firm promoting small businesses that create jobs in the US.

“The goal was to create a instrument that combines the best of debt and equity,” said Lackland in an interview. “You didn’t really have a funding option for people who just want a damn good business.”

The strategy comes with risks. Revenue-based lending is growing, but the creation of new SaaS startups appears to have slowed from its peak two or three years ago, reports venture firm Redpoint. New SaaS startup fundings dropped by more than half to 423 in 2015 over the previous year. A second worry is that a recession could reduce portfolio companies’ revenue. Repayment rates may fall or companies may slip into default with assets to claim (so far, Lighter Capital reports, default rates are under 2%).

Finally, the market for revenue-based lending may be a victim of its own success. “Revenue-based lenders will run up against the banks,” says Mansfield of Square 1. “As soon as a company can switch to low-cost debt, it is likely to do so. And it’s almost impossible for any alternative finance to compete with banks at that level.”

For now, revenue-based lending may ease one of the most cited problems for small business owners and young tech startups: access to capital.

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