Today, there are various startups offering âNon Dilutiveâ, âNo Strings Attachedâ, âFounder Friendlyâ financing for SaaS Companiesâ. Is it too good to be true? How does this work? Are there hidden strings attached? Letâs dive in.
Factoring itself is a term that applies to the process of converting future cashflows into cash today, minus a (usually small) percentage. Typically, the financing provider purchases the legal title to the receivable from the Company today and they take on the risk of collecting on that receivable at itâs due date. Ex. Company ABC (âABCâ) has a receivable from Customer XYZ (âXYZâ) for $100, due in 90 days. Financing Provider (âFPâ) will pay ABC $95 today and take the risk that XYZ actually pays them back in 90 days. ABC enjoys the benefit of getting cash now, XYZ is unchanged since they still have 90 days to pay, and FP makes $5. In essence, this shifts both the liquidity requirements and the credit risk to FP, the firm whose business is to deploy capital and get paid to take that exact risk.
There are two major components to pricing this type of risk: (1) the counterparty risk of XYZ (not of ABC). The more unlikely XYZ is to make good on their payment, the less FP should be willing to pay for that receivable and (2) the time until the receivable is due. Theoretically, a 90 day receivable should carry less risk than a 12 month receivable (sometimes referred to as âterm premiumâ)
Itâs also useful to note that factoring has been used extensively in industries such as trade finance for decades (if not centuries) and is typically used for highly predictable cash flows. The proliferation of the internet and connected devices has led to a boom in SaaS companies over the last two decades, which in turn has led to an increasing creation of predictable SaaS revenue streams and thus a natural application for factoring. A handful of startups have looked at this as a new opportunity to build a business and have stepped in to provide quick and easy to access capital through a simple user interface. If you are in the startup or VC world and spend any time on the internet - and especially on Twitter - youâve most likely seen ads for a handful of high profile platforms that have attracted substantial amounts of equity capital thus far.
Letâs zoom out for a minute and put these platforms into context alongside a wider spectrum of financing providers for early stage startups (venture debt, recurring revenue financing, convertible notes, promissory notes, Asset Based Lending, etc.) While it is just one sliver of the broader financing market, weâre going to focus only on venture debt and recurring revenue financing (RRF) for this comparison.
Typically, venture debt is a loan secured by a lien on the operating company. If the loan is not paid back then the lender has the ability to go to court and force the company to return any value that might be available on the Companyâs balance sheet.
Usually structured as a term loan or a revolving line of credit to be repaid in 6-36 months.. Term loan provides a fixed loan amount, line of credit can be increased and decreased (usually with a different interest rate for the drawn portion and for the undrawn portion).
Can come with or without covenants on the business - eg. total leverage, min tangible net worth, minimum cash, minimum runway, no incurrence of other debt
Sized based on the most recent equity round and/or cash currently on the balance sheet
Lenders can charge an interest rate in a wide spread, generally from ~5-20%. Economics can also come in the form of upfront fees, closing fees, early prepayment penalties and warrants.
Some of the most well known players are: Â SVB, WTI, Triple Point, Victory Park, Atalaya
Recurring revenue financing offerings are generally unsecured and non-committed forms of capital. Effectively they are IOUs sized according to revenue or expected revenue, and then adjusted based on a variety of other factors like marketing spend, industry, churn, and other KPIs. Since the financing is not secured by a lien on any real assets, the platforms are primarily focused on tracking revenue. They integrate with bank accounts (what would have been an almost impossible task a decade ago, pre Plaid) and then skim a % of revenue periodically to pay down the borrowed capital. A key selling point the platforms lean into is that they are providing growth capital, not operating capital. By giving a Company credit for revenue that they have not yet earned they can bring forward revenue that can be spent now to ensure that revenue and more can be earned in the future.
Some of the key players are: Clearco (fka Clearbank), Pipe, Capchase, Liquidity Cap, Â Lighter Capital, Cerebro Capital.
Each has their own nuances and vertical speciality but generally they all:
Letâs go deeper on perhaps the industryâs best known player, Pipe. Having attracted an eye-popping $2B valuation in less than two years, Pipe has attracted attention and capital. Splashed across the internet are Pipe ads offering the ability to âconvert MRR into ARRâ, âinstant payout. No dilutionâ and the ability to âgrow on your terms, never take on debt or dilution again.â The newer players are concentrating their marketing efforts around the promise of speed and low barriers to access non-dilutive cash. In the current market environment with equity capital also flowing quick and fast, itâs an extremely attractive alternative for founders waking up to the reality that dilution is not always the best solution.
A key differentiator in Pipeâs business model is the use of a two-sided marketplace to bring financing to their customers. In more straightforward terms, when a Company signs up to use Pipe, Pipe makes no promises that their platform will actually be able to finance the Companyâs receivables. Instead, Pipe posts the Companyâs assets on an internal marketplace and institutional buyers bid on the receivables (or not).
Structurally, this looks almost identical to commercial paper programs run by investment banks. With the major exception being that instead of multi-billion dollar corporates using CP to finance short term AP, payroll and inventory costs, Pipe is squarely focused on serving startups, and is willing to finance anything and everything.
Donât forget, the capital these platforms are deploying still has to come from somewhere. These avenues are the same as they always have been - marketplaces, banks or funds. Customers used to interact directly with each of these sources in what was broadly a slow and inefficient process. Now the customer is one step removed. Each platform takes it upon themselves to keep funding open and available, each in slightly different ways - Pipe is a two sided marketplace that allows liquidity buyers and sellers to interact, Capchase and Clearco each have raised their own borrowing facilities from funds. Â
From a Customerâs perspective, while this removes the need to go through what is often an expensive and time consuming process to raise credit capital, direct relationships with the right provider can be exceptionally important during difficult times. Many times those relationships can mean the difference between survival and failure.
RRF platforms ability to deploy capital quickly makes them great to use when time is of the essence or as a short term bridge. But with making high consequence decisions like taking capital on, the quickest solution is not always the best for every instance. While they have a place in a Companyâs capital structure, they should probably be used in parallel with other capital sources.
Remember, it will likely be when the situation is at its worst that you need capital the most. At this time it will most likely also be scarce and expensive (if available at all). Having some longer dated borrowings and strong equity support is important to be able to weather inevitable storms. There is no one right answer as disparate businesses will be able to operate in vastly different ways. What is true is that businesses that anticipate problems and build a resilient capital structure will outperform those do not.
