The Best Way to Fund a SaaS Business: Debt vs. Equity Financing

As spending on SaaS continues to grow steadily, there has never been a better time to enter the software market or improve existing software offerings. Early stage SaaS business leaders must decide on the best funding method for their organization as soon as they decide their business is viable. They are usually offered one of two choices: debt-based funding or equity-based funding. Read on to learn how these funding methods are different and which SaaS companies should use to finance their business. 

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Funding Choices for New Businesses

Debt-Based Funding

Debt-based funding (such as loans) involves borrowing cash from a creditor and paying it back with interest at a later time. Creditors are usually not given any control over how the business is run. Lenders also typically favor businesses with a low debt-to-equity ratio. Loans that are paid back on time can make it easier for businesses to procure more funding in the future should the need arise. 

Equity-Based Funding

Equity-based financing is defined as taking funding in exchange for a portion of the company’s ownership. This sale of equity means that businesses are not required to repay the funding that they receive. However, business owners will provide investors with a return on investment in the form of dividends or stock returns. 

Key Features of Debt-Based Funding

Allows SaaS Leaders to Plan Growth at a Slower Pace Than Venture Capitalists Typically Require

Debt allows SaaS business leaders to retain complete control over the pace at which their business grows. Unlike investors, lenders are not concerned with business growth rates or future business plans as long as the borrower makes their payments on time.  

Companies Must Plan Long-Term Cash Flow to Pay Funds Back With Interest

When lenders are not involved in business operations, leaders have more autonomy but this method of financing also means they must plan cash flow carefully. Failing to do so can lead to interest or penalties. Financial teams often have to keep an eye on cash flow to ensure that the business has enough capital to maintain business continuity even as loan repayments are made. 

Key Features of Equity-Based Funding

Equity Financiers Can Provide Significant Funds in a Short Period of Time

Financing through venture capitalists and other equity investors is more agile than other loans, and access to large sums helps team leaders get their plans off the ground and scale the business quickly. Investors have an inside view of management and strategy, and consequently are more likely to provide additional funding to navigate challenging business conditions. 

Business Leaders Must Accept Their Ownership Position Being Diluted in Exchange for Funds

A major feature of equity-based funding is the loss of control that business leaders must accept should they decide to fund their business in this way. Venture capitalists, in particular, tend to take a greater interest in business strategy, decision-making, and the effectiveness of operational processes. Equity investors can sometimes have veto power over certain aspects of the business. This diluted ownership can also come with benefits for inexperienced business leaders as investors can guide businesses to long-term success with their insight into the operation and the wider industry. 

How to Decide the Best Funding Option and Structure the SaaS Funding Process Effectively

Consider How Quickly Capital Is Needed

The first step business leaders must take before deciding how to fund their business in the early stages is determining how much capital is needed and how quickly. Debt-based funding is often limited in the early stages of a business due to the risk involved in providing these loans. Equity funders, however, are much more likely to take risks as long as their potential investments have significant earnings potential. 

Determine How Much Complete Control of the Business Means to You

SaaS businesses can differ greatly from one another. The saturated nature of the software market has led to an increasingly competitive business environment. Venture capitalists have pumped increasing amounts of money into the SaaS market. This increased investment raises pressure for a quick and significant return. 

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In this environment, business decisions and strategy can often be the difference between success and failure for software businesses. Business leaders must decide if they’re willing to include another stakeholder with power to influence decision-making processes. Loans can help business leaders retain complete control over every facet of their business while equity funding requires ownership to be shared with investors. 

Compare How the Business Will Pay For Financing Under Each Option

Financing is essential but SaaS business leaders must consider the tradeoffs. Debt-based funding requires the cash to be returned with interest in a specified time period. Business leaders who are confident of generating significant cash in the short term might find this appealing. SaaS companies that wish to take advantage of a long-term plan and need time and money to lay groundwork might want to consider equity-based financing that does not require repayment in the form of interest or immediate cash repayments. 

Both equity-based funding and debt-based funding allow SaaS businesses to fund business operations and growth. Each of these options brings a series of benefits and drawbacks that business leaders must consider as they build their operations and plan their future. 

Business leaders can maximize the benefits of these funding options while limiting the impact of their drawbacks by adopting a hybrid approach to funding. However, this approach can only be successful if finance leaders manage incoming funds effectively and can view the effect that spending has on business operations and performance. 

If you would like to find out how Place’s solution can deliver greater financial visibility to SaaS businesses during early financing and growth periods, schedule a demo with us today.

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