How Much Debt is Too Much Debt for a SaaS Company?
A Guest Post by:
SaaS Advisor Ltd.
Todd is an innovative advisor to SaaS companies on growth strategies
Debt is a great way to fund a SaaS company — it allows shareholders to maintain their ownership position yet still fund their growth plans. Debt, however, needs to be repaid at some point, and there are only three ways to repay it:
- Repay through earnings/cashflow
- Raise capital
- Sell the company
Areas of Risk
Properly levered SaaS businesses can always reduce expenses and generate sufficient cash to make their debt payments. If a SaaS company borrows too much, however, and the debt burden is beyond their ability to repay through internally generated cash, they will be forced to either raise money or sell the company. As most entrepreneurs know, selling the business or raising capital is not something you want to be “forced” to do.
From an external perspective, an over-levered SaaS business is reliant on a well-functioning capital market at the exact moment it needs to raise capital. If the company needs to raise money at an inopportune time, 2007 or 2008 for example, it will either pay a very high price, or possibly even be forced to sell because capital is not available.
From an internal perspective, any SaaS business can hit a slow patch in bookings or suffer an unexpected churn event. When these things happen concurrent with the need to repay debt, the company will need to raise money at the worst possible time. This scenario may result in a down-round, forced sale of the business, and/or the founder being forced out. If the business were properly levered, it would have a chance to re-group and raise capital at a later date.
As you can see, the practical definition of “over-levered” is an amount (and structure) of debt that cannot be repaid from internally generated cash when due. In the case of a SaaS business, this does not mean it needs to be profitable at the point it borrows money, but it needs to be able to become profitable if necessary.
For some SaaS companies, “over-levered” starts at $1.00. Companies with a high cash burn relative to MRR may need to cut expenses by 60% or more to generate any cash. Headcount reductions of that magnitude often trigger irreversible employee and customer attrition. Generally speaking, if the monthly cash burn of a SaaS business exceeds the monthly revenue, (expenses are twice as much as revenue), the business will have a difficult time generating any cash from operations and should not be a borrower.
In these high burn companies, debt is not a very useful funding source anyway as it will only extend the cash runway a few months. (More to come in future posts on how to optimally use debt in a SaaS business.)
Debt When Modestly Unprofitable
If a SaaS business is burning some cash, but its monthly cash burn is below the level of its MRR, it likely has the capacity to generate cash without firing a large number of the employees, and can therefore service a certain level of debt. In looking at over 1,000 SaaS companies and modeling their expense structures, SaaS businesses that are modestly unprofitable can typically support a total amount of debt equal to 4 to 7 times their monthly revenue. This debt can be in the form of a term loan, or a revolver. Keep in mind, however, no business can repay debt from internal funds if all the principal is due at once.
If the SaaS business is already profitable, it’s quite possible it could pare back expenses and generate sufficient cash to repay total debt as high as 12 times its monthly revenue.
The bottom line is, when a SaaS business borrows more money than it has the capacity to repay through internal operations, it is exposing itself to greater risk than it should, and is handing over a certain amount of control to external parties (lenders and investors). Sometimes this works out just fine, but other times it does not.
In future blog posts we will discuss the optimal use of debt in a SaaS business, including when to borrow, how much, under what structure, and the little “got ya” details to watch out for.
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