Alex Danco wrote a provocative article this week on the changing capital stack of venture-backed startups. His summary view is that founders of businesses with contractual, recurring revenue are diluting themselves unnecessarily with successive equity rounds. Instead, he predicts that, in the near future, startups will use debt capital to finance the acquisition of these relatively stable cash flows.
David Haber subtweeted the post with a good summary of the key question it raises:
The most interesting question here is whether there are mispriced cash flows (currently being entirely funded with expensive equity) but could be more efficiently financed by debt. Royalty Pharma did this by buying pharma royalty interests, Vista did this in SaaS. What’s next?
Selling equity is, indeed, an expensive way to finance a company’s growth.
The below is a list of software companies that went public in 2019, how much equity they raised prior to IPO (according to Pitchbook), and the disclosed equity stake of all named founders in the companies’ respective S-1 filings:
Cloudflare (NET): $404m raised, 27% founder-owned at IPO
Livongo (LVGO): $237m raised, 12% founder-owned at IPO
Medallia (MDLA): $338m raised, 30% founder-owned at IPO
Slack (WORK): $1.2b raised, 12% founder-owned at IPO
Fastly (FSLY): $220m raised, 16% founder-owned at IPO
Zoom (ZM): $161m raised, 22% founder-owned at IPO
PagerDuty (PD): $173m raised, 7% founder-owned at IPO
These are all world-class companies, and yet, on a dollar-weighted average basis, founder ownership in this group is only 17% at IPO. Employees may hold an additional 10-20% of the cap table in stock options or RSUs, but, in nearly all cases, investors own a majority of the business at IPO.
Debt may seem like an attractive solution to excessive dilution — more so when companies have built up cohorts of reliable historical cash flows from customers. For example, PagerDuty (PD) had nearly 10,000 customers at IPO and a dollar-based retention of 135%. Its cohort chart looks like a beautiful layer cake.
Alex goes on to quote Jonathan Hsu of Tribe Capital, who sees opportunity for debt capital in such a layer cake chart:
When you acquire some customers and they start yielding revenue that behavior sounds an awful lot like buying a fixed income instrument and there is a lot of sophistication around how to value those cash flows. In some sense, what we’ve seen over the last decade is that software enables a whole new business model – recurring revenue – which is both good for customers and is good for investors. It’s good for investors because it becomes more “predictable” in the sense that it starts to look more like a fixed income yielding asset and thus more amenable to traditional financial techniques and thus potentially “in scope” for a wider set of investors.
In the case of PD, the equivalent annual yield is something like 35%. Even “mezzanine” debt at a 12% cost of capital would leave an ample surplus. Further, if this “SaaS-debt” could be bundled together across a mixture of companies with different customers and securitized against their respective contracts, companies could lower the cost of debt capital even further through diversification.
And yet, even writing these paragraphs makes me nervous. The wonderful thing about equity is that it aligns incentives. Debt tends to do the opposite. Debt holders get paid even if the business is floundering. They do have an incentive to keep the company alive, so that they can continue to earn a yield, but they will also be the first ones out the door when something dramatic changes.
Startups need a large margin of safety when utilizing debt. Productive uses of debt include lines of credit that are asset-backed, non-recourse to the parent company. If a set of assets (e.g. receivables, inventory, etc) go bad, the debt providers can only lay claim to those assets, and not the company’s IP, other assets, or anything else. The cost of capital tends to be higher for these facilities, but you’ll sleep better at night knowing the damage can only be minimal if the world changes.
Perhaps that framework can also be extended to the receivables on a SaaS contract. However, I worry that companies tend to overweight the stickiness of their own products in the long-term, and underweight potential disruption by a new competitor. High net dollar retention for your expensive SaaS product is cool until, for example, an open source upstart commoditizes your product and forces you to drop prices. Some businesses are more defensible than others, but no revenue stream in software is forever static and dependable. Gavin Baker made this point clearly:
And for investors: SaaS switching costs feel like they are going down rather than up so caveat emptor whether buying future putative ABS instruments or equity.
I suspect we shall see debt used increasingly in venture-backed businesses. My hope is that operators will constrain its use to areas where debt is a more natural fit. Personally, I’m not there yet on its application to SaaS revenue.