Best practices for B2B software startups
Insights into the financing stack: Recurring Revenue Financing.
re:cap: How recurring revenue financing scores against the most common types of startup funding
This article is brought to you by re:cap, a financing platform specializing in recurring revenue financing. Contact details and a link to their website can be found under the article.
Today, SaaS startups have numerous ways to get the funding they need and leverage their business. Bootstrapping, equity, and debt capital are common - but those aren't your only choices. Another innovative financing method is recurring revenue financing (RRF), a fast-spreading financial solution that has proven its merits time and time again. Boasting numerous advantages over other forms of finance and only growing in popularity, RRF is quickly becoming indispensable for any ambitious SaaS venture.
Financing platforms such as re:cap provide startups with recurring revenues and a simple and quick way to access capital by converting their future revenues into immediate, upfront payments. Startups can access the financing line whenever they need it and only pay for what they actually use. In as little as 48 hours or less, you can unlock funds without giving up any equity ownership - making it the perfect line of credit alternative for startups looking for fresh capital efficiently, without the hassle of lengthy fundraising.
Are you also thinking about RRF for your business, but don't have a proper overview of the different types of financing and their advantages and disadvantages? Then the following overview can help you to get more clarity.
Recurring revenue financing or venture capital?
Most startups use venture capital (which belongs to the category “equity financing”) as part of their financing strategy. It is a clear deal: Venture capital funds provide startups with capital and get company shares in return. Especially in their early phases, venture capital (VC) is often the only possible option for startups to receive external funding. And it has many advantages: A well-fitting business angel or VC fund brings industry expertise, years of experience, and a big network, and the startup’s image benefits as well. That can help a lot when trying to win new customers, partners, and talent. Unfortunately, venture capital holds disadvantages, too. Whenever startups get funding from VCs or business angels, they can’t avoid diluting their shares. Founders will have to involve the investors in strategic decisions and therefore partly lose control over their company. In addition, this type of financing can be very time-consuming since it usually takes many months to complete a financing round. So if a startup needs capital fast, venture capital is usually not the right choice.
A direct comparison between RRF and venture capital reveals a number of important differences, mainly: With RRF, there is no dilution and no loss of decision-making power. In addition, with RRF, capital is available much faster and the effort is low. On the other hand, RRF is only available for startups in growth phases, which is usually after the seed phase. While startups are still in the product development phase, their ROI on different investments and activities is not yet calculable. If they need growth capital in this phase, most times VC is the right choice for them. As soon as they have more stable revenues and plan targeted measures such as marketing or sales, where the ROI is calculable, RRF is often the better alternative. Startups can also combine both methods: Using RRF to flexibly extend the runway and thus optimally prepare for the next big funding round when the market situation is good. They can also use RRF to increase the total amount of a financing round without further diluting their capital stack.
Recurring revenue financing or venture debt?
Venture debt is debt capital and has similarities to a bank loan, but is provided by a venture debt fund. It is aimed precisely at those startups for which a traditional bank loan is not (yet) an option: startups that have not yet reached a break-even point and that do not have sufficient securities in the case of insolvency. Venture debt, however, is no option for startups in a very early stage of development; suitable companies must have already completed at least one equity round. They should also be growth- and profit-oriented. Venture debt is repaid in installments, usually over a period of three years. In addition, there is interest, which on average is significantly higher than for bank loans. But that's not all. Venture debt also comes with various conditions and additional covenants that are negotiated on an individual basis. Warrants for the venture debt provider can also be part of this agreement. An advantage of venture debt is that SaaS startups can use it as a bridge until the next funding round, i.e. to extend their runway. Depending on the agreement, it is also possible that this does not involve dilution - although in the majority of cases it does, namely once warrants have been agreed in the contract. Similar to VC financing, the process is complex and lengthy. Venture debt is therefore not suitable for startups that need capital fast. Furthermore, interest rates for venture debt are usually quite high, 15 percent is common.
A comparison of venture debt and RRF reveals similarities and differences. Both methods are suitable for startups that have already completed the seed phase and generate regular revenues. However, unlike RRF, venture debt is usually dilutive and the financing process takes months. On the other hand, venture debt can often provide larger financing amounts than RRF, and the repayment phases are usually longer. Venture debt is therefore particularly suitable for startups that need a lot of money, mostly startups with high growth potential that want to scale strongly with the new additional capital. RRF, on the other hand, is more suitable for startups that need comparably smaller sums but want to deploy them faster and not dilute their shares. These are, for example, startups that want to raise money for short-term investments such as technology, marketing, or sales. For a runway extension, on the other hand, both methods are equally suitable.
Recurring revenue financing or revenue-based financing?
With revenue-based financing (RBF), startups receive capital from investors who, in return, get a fixed percentage of the startup's gross revenues. The payments to the investor are therefore directly dependent on the respective revenues and are matched when this rise or fall. In case of faster growth than expected, a repayment cap is enforced, which usually lies around 1.5 - 2.0x of the invested sum. The repayment cap is agreed in the contract between the investor and the startup, which is to be paid in total by the startup and which is several times higher than the amount originally invested. As soon as this sum has been paid off, no further payments are made to the investor. This method is only suitable for startups that have passed the seed phase and can already show decent sales. Its biggest advantage: Revenue-based financing is not dilutive. It is also easier and faster to access than venture debt or venture capital. Since revenue-based financing is not dependent on company valuations and exit plans, startups can use it to make strategic decisions quite freely. It is therefore well suited for runway extensions of VC-financed startups, but can also be used for financing completely without VC money. Since the price of this loan is usually quite high, revenue-based financing does not suit all startups.
RRF and RBF are the financing methods that have the most in common, but they also differ significantly in some respects. While both methods are only suitable for startups after the seed phase and with regular revenues, RBF is a repackaged loan. The repayment amount is usually many times higher than the loan, hence the costs are relatively high and unpredictable since they depend on the size of the actual revenues. Meaning, if the revenue increases, costs increase as well, as they are a fixed percentage of the revenue. RRF is significantly more predictable and less expensive, and software companies with subscription models get easy and fast access to capital by converting their future annual recurring revenue in exchange for immediate upfront payments. The loan amounts can usually be chosen very flexibly (depending on the ARR, of course), accessed whenever the capital is needed, and the money is available almost immediately. The cost of capital is much lower than RBF, and discount rates are usually 2-15 percent.
The differences are mainly found in the purpose for which the money is to be used and how long repayment periods can take: RRF is suitable for shorter periods and usually has to be repaid more quickly - so is particularly suitable when smaller amounts are needed fast. However, as long as your startup has at least six months of runway, RRF can be used flexibly as long as it’s needed. RBF, on the other hand, is also suitable for somewhat longer periods of up to three years, and can therefore be used for longer-term measures such as building teams or product development. When choosing a refinancing partner, one should also pay attention to the legal set-up and whether this corresponds to the regulatory requirements. Furthermore, the financing partner should ask for the uses of the requested financing, in order to understand if the company's purpose is achievable. Pure money brokers should be treated with caution and are rather critical for companies in the short- and medium-term.
What’s the best financing method for your startup?
With so many financing methods to choose from, the decision can be difficult. Startups must always consider their individual situation, objectives, and business model when making a choice. For startups in the early stages of growth, venture capital continues to be a great option for gaining access to large amounts of funding. Those with revenue streams and calculable risks can look into RRF or RBF which offer flexibility and faster processing. Combining different financing models and optimizing the capital stack can be beneficial as well; it gives businesses maximum advantage from each source while also providing greater protection during turbulent times like these - ultimately giving entrepreneurs more choices than ever before.
