A Large Equity Financing Can Kill Your SaaS Business
The general hypothesis many founders have is, “If I can secure more capital, I can serve more customers, expand across more verticals, and grow faster.” After all, when the money is offered you should take it, right?
An equity funding offer is not necessarily a validation of your business model. Companies that fit in certain hot categories (like fintech, clean energy, and so on) actually find it relatively easy to access funding—even if it’s not suited to their business.
This post describes two different paths to growth and outlines ways founders can identify whether equity capital will help or hinder their business in the long run.
Two paths to SaaS growth
TIMIA works with promising SaaS companies every day. Most of them take non-dilutive revenue financing loans from us. After that, they generally take one of two paths:
- They continue to grow their business sustainably and deliberately with non-dilutive capital and by reinvesting revenue from paying customers
- They are offered venture capital, they give up a lot of equity, and they take a bet on exponential growth
Those that take the first path are likely to have steady and predictable growth, leading to a potential exit down the line.
Those that take the second option have a much riskier future with a 75 percent failure rate—and no plan B or middle outcome.
Typically, they accept the venture money and celebrate it in the manner that most startups tend to do. They revise their steady, sustainable growth plans to align with the expectations of the venture capital firm and scale fast. They ramp up hiring, invest in sales and marketing, and sit back to watch their skyrocketing growth.
If sufficient growth in revenue doesn’t materialize, it becomes easier to spot the cracks in the foundation. Eventually, the founder ends up being forced to sell, debt and venture shareholders are paid, and the common shareholders can often get nothing.
The reason things can go pear-shaped is that money can’t solve certain problems in a startup—sometimes it can actually cause more.
Follow these three steps to discover if your business will actually benefit from taking on equity financing:
- Perform an honest assessment of the growth prospects for your business
- Identify if you have a customer acquisition problem or a market size problem
- Look at the underlying metrics to see if you need to spend more money
1. Perform an honest assessment of the growth prospects for your business
Before accepting equity, look at your business and make an honest call about its potential. Look at your product and compare it against existing offerings, understand if the use case can be applied to new verticals, identify the market size, and so on.
Once you’ve done your research, decide if your business has the potential to be a great $50 million business or a great $500 million business. The approaches you’d take to finance those two potential businesses are completely different.
If you decide it can be a $50 million business, turn down the equity funding and grow deliberately and sustainably by reinvesting revenue from paying customers. If you decide to shoot for the $500 million, you may need to finance the business with additional capital from equity.
2. Identify if you have a customer acquisition problem or a market size problem
Look at the market research alongside your own business metrics and ask yourself, “Do I have a customer acquisition problem or a market size problem?”
If you have a customer acquisition problem, investing more sales and marketing may help. Explore non-dilutive forms of capital to solve this problem. Look at government grants, bank credit, revenue loans, and so on. If—and only if—you have exhausted all these options, go talk to a venture capital firm.
On the other hand, if you have a problem with market size (i.e. there isn’t a big enough market for you to grow exponentially), it doesn’t necessarily mean you don’t have a valid business. It just means that your growth will be slower as you expand to reach your full potential in your existing markets.
Looking for non-dilutive capital?
TIMIA Capital works with B2B SaaS companies between $2 – $20million ARR.
3. Look at the underlying metrics to see if you need to spend more money
A metrics-driven approach can help you identify when you should pull back or invest more money in your business. The following are particularly valuable in identifying whether you need to spend more money to achieve your planned growth:
Lifetime value (LTV) and cost of customer acquisition (CAC)
A great way to understand your business is to ask yourself, “Can I make more revenue from my customers than it costs me to acquire them?” Forentrepreneurs.com recommends that LTV is three times CAC and the time to recover CAC is less than 12 months.
The time to recover CAC is the difficult one for startups. The pressure to fund customer acquisition can tempt founders to go down the equity funding path, even if it’s not the right option for their growth plan.
Customer satisfaction and churn rate (dollars and logos)
If your customers are happy with the service, they will stick around for a long time and LTV will increase considerably. On the other hand, if a customer is unhappy, they will churn quickly and the business will likely lose money on the investment that they made to acquire that customer. Customer satisfaction and churn metrics can shine a light on whether you’ve achieved product-market fit.
Revenue growth is critical. SaaS companies can look at net and gross monthly recurring revenue growth and net and gross annual recurring revenue growth to determine their growth rate.
Founders often believe that as soon as the business has shown that it can succeed, it should invest aggressively to increase the growth rate. This isn’t always the smart approach.
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The bottom line is that you shouldn’t take capital just because it’s offered to you. Be honest with yourself about your business, identify the real problems your company faces, and look at your metrics to understand if you actually need more capital in order to succeed. You could potentially turn a $50M exit into a zero exit if you chase the wrong goal.
Mike Walkinshaw, CEO
Mike joined TIMIA as the CEO in August 2015. He is experienced in revenue financing, venture debt and venture capital investing. Previous to TIMIA, he was the Co-Founder and Managing Partner of Fronterra Capital, as well as Managing Partner, CFO at Chrysalix Energy. Before working on the finance side, Mike worked in the technology manufacturing sector in product and program management, strategy and planning.
Mike has a Bachelor of Commerce from University of BC, and a formal CPA designation.