Revenue-based Financing: The Happy Medium for Micro SaaS?
Bootstrapped startups are becoming more popular by the day. Among them, micro SaaS ventures offer entrepreneurs the best of both worlds: The chance to build something of one's own without getting tangled up in the intricacies of attracting investors. People know that venture capital comes with strings attached. Once aware of that, they start to believe that it may not always be worth the dilution and loss of independence unless you hit the jackpot and win big.
Financing just in case
However, remaining bootstrapped has its challenges, too. Bootstrapping does not work in every market. Markets that reward growth at all costs are not suitable for bootstrapped companies. Bootstrapped companies do not enjoy the resource abundance that VC-backed companies enjoy, which shows in their performance. Compared to a VC-backed company, a bootstrapped startup takes two more years to $1.5 million in ARR and four more years to $10 million in ARR. These figures underline the fact that bootstrapped companies will fall behind VC-backed companies in the race to scale and may have to be content with a tiny slice of the pie.
Micro SaaS companies usually enjoy a small cash buffer until they scale. Just a few months of weak performance can spell doom for them. They could use a capital injection when the situation becomes too dire, but micro SaaS startups that refuse to receive venture capital do not have that many options to access capital.
Banks are reluctant to lend to these companies, which lack the assets and inventory to collateralize a loan. So, apart from a scenario where the founder's personal assets underwrite a loan, banks do not prove much help to micro SaaS businesses. Luckily, micro SaaS founders who value independence and are unwilling to chase high growth are not beholden to venture capitalists. Revenue-based financing offers a viable alternative here.
Revenue-based financing explained
In revenue-based financing, an investor agrees to invest in a startup in return for a flat percentage of the gross revenues. The monthly payments generally amount to between 2 to 8 percent of the startup's revenue, continuing until the investor receives 1.35 to 2.0 times the principal amount he invested.
Revenue-based financing involves no sale of equity; therefore, it is non-dilutive. The founders remain independent in their decision-making and just have an obligation to pay back the loan as a portion of the monthly revenue until they hit the cap.
The repayments are flexible in this form of financing. If you have had a rough month in terms of revenue, the amount you pay back will be smaller, too, so that your cash flow problems are not compounded in an already bad month. If your company is doing well, you will hit the cap sooner. This flexibility can be invaluable to a micro SaaS company.
Revenue-based financing stands somewhere between equity financing and bank financing in terms of cost. Bank financing is cheaper than revenue-based financing because the assets used as collateral in bank financing reduce the risk for the bank and bring down the interest rates. However, revenue-based financing is preferable to equity financing for two reasons: The interest paid counts as a tax deduction for the startup, and the effective interest rate resulting from the sale of the company turns out to be much higher in equity financing.
Revenue-based financing resembles invoice factoring in that the future revenue is collateralized in the former, just like how invoices or money owed underwrite a loan in the latter. For a startup to be able to receive revenue-based financing, it should be generating revenue, though. E-commerce businesses and SaaS companies with monthly recurring revenue are good candidates for this kind of financing. Very early-stage startups that struggle to generate revenue will not be able to access funds using this method.
Another downside of revenue-based financing is the relatively small size of the funds available compared to equity financing. The average loan size in this type of financial arrangement rarely exceeds a few million dollars.
Micro SaaS companies have different needs than regular SaaS companies and thus need custom solutions. It takes some creativity to stay independent and cash-solvent without diluting ownership and sacrificing control over the company's future. Revenue-based financing is one of those creative alternatives that can help micro SaaS businesses deal with a temporary cash drought. As long as your micro SaaS startup has a sound business plan and just needs a bridge loan to overcome a financial hurdle, revenue-based financing is not a bad option.