Financing SaaS ventures

The pay-as-you-go business model of on-demand software makes it more difficult for up-and-coming vendors to reach break-even point than with conventional licensed software. Instead of signing a handful of customers to get enough money in the bank to start covering its overheads, an on-demand vendor needs to sign up dozens or even hundreds, depending on the market segment it targets and the value of each user subscription.

It takes determination and commitment to get through those early days, not only from the founding team, but also from their financial backers. Fortunately there are a growing number of VC firms that understand the economics of on-demand, but not every founder wants to give up a large slice of equity in return for a secure financial backing.

So I was interested to get an email a couple of weeks ago from someone who knows more than most about the financial requirements of the on-demand model. Chris McCleary (pictured) founded USinternetworking, one of the earliest pioneers of software as a service, back in the days when hosting enterprise applications such as SAP and Peoplesoft on behalf of customers was seen as the premier model for SaaS. McCleary's company, USi, was the first application service provider (ASP) to list on Nasdaq in an IPO in March 1999, and became a poster child for the nascent ASP industry.

McCleary is now a partner with Blue Chip Venture Company, and his email was to let me know about a new venture backed by BCVC, called SaaS Capital.

"The uniqueness of this company is that it provides working capital debt financing for SaaS providers and will lend against the future value of the provider's customer contracts," he told me. "This has always been an issue for today's software companies — the amount of incremental capital required due to the shift away from paid up perpetual licenses in favor of a long term service contract."

SaaS Capital has equity finance of $2.3 million but more importantly it has access to $10 million debt capital from an unnamed leading financial institution. The notion of lending against the value of contracted subscriptions means that on-demand ISVs can effectively 'dip into' their future revenues to meet their current working capital needs. It will appeal to on-demand entrepreneurs who need to access more capital to expand but are reluctant to dilute their equity stake in the business by taking on extra venture finance.

SaaS Capital limits its exposure by satisfying itself of the "financial and operational viability" of the ISV and its hosting provider. If the vendor should nevertheless fail for any reason, the company will take over and draw on its own resources and expertise to keep the applications up and running for contracted customers.

I wanted to get an independent take on this idea, so this week I asked Mike Fitzgerald (pictured), general partner and co-founder of Commonwealth Capital Ventures, what he thought of it. Commonwealth is a long-established firm that invests mainly in the Boston and New York areas. It has invested in several on-demand vendors, including Constant Contact, SoundBite Communications and e-Dialog.

"The nice thing about the SaaS business is, if the customers are getting some value out of it, then even if the business [management] messes up, the customers are not going to go away," he said. "There's still value in the business and you can take it over and just run it for cash."

Lenders are often not up-to-date with the financial model of an on-demand business, so debt finance has not been readily available in the past, he added. But he cautioned against drawing on future revenues too early in a company's lifecycle.

"If a SaaS company isn't profitable, it ought not to be borrowing money," he said. But once it has shown it can cover its costs, then borrowing to fund expansion can make sense. "If you need more capital to grow, fine. A lot of your expenses are sales and marketing, and you can control that."

This is the scenario SaaS Capital seems to be targeting, preferring companies with $4 to $40 million in annual revenues and a proven record of customer renewals. It will be interesting to see how many on-demand vendors decide to take on this type of debt capital as an alternative to equity finance.