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Securing a deal with venture capital (VC) investors is generally a strong signal for of success, yet prominent founders, such as Tom Blomfield (GoCardless, Monzo), have lately raised their voices to shed some light on the drawbacks of VC: intense competition between VC firms to deploy capital in faster cycles at ever higher valuations and a process that is rigged against founders: For instance, a well-known VC firm made him wait for hours in the lobby, then the partner appeared to the meeting barefoot and “lit a cigarette and smoked it in his office, windows closed” – you’d think founders could use their time more wisely, but in reality there’s immense pressure to comply in order to get funding. Popular arguments against venture capital funding usually go along the lines of “What’s best for VCs often isn’t best for founders.”, “The fundraising process is broken”, or more sophisticated ones cite the marginal dollar problem, which states that the rapid increase in VC money that is pumped into a start-up to enable blitzscaling diminishes the returns per dollar invested over time.
Early stage start-ups launching disruptive new business models or investing new technologies need investors that embrace the speculative nature of VC investing. It’s often the only way to enable the testing ground of new business ideas that later become large global companies, as in the case of Apple or Amazon. If you’re having extremely high ambitions, crazy ideas and want to take on markets with a sufficiently large addressable market segment, giving away equity for cash is the way to go.
The reality is as always not black and white. VC is an integral part of the global capital structure that has unlocked amazing firms, yet it’s not the right fit for every type of start-up and every maturity stage. While many tech founders opted for VC funding simply due to the lack of suitable alternatives, the industry is now ready for new financing solutions.
Here’s why: As the tech and specifically the software industry has matured, the days of traditional, packaged software licenses are gone. Software-as-a-Service (SaaS) models have become the de facto standard for monetising software, i.e. through recurring subscription fees. SaaS and subscription businesses have become so mature and integrated into modern businesses that their performance can be assessed via industry specific metrics, such as customer acquisition cost (CAC), customer lifetime value (LTV), annual contract value (ACV), return on advertising spend (ROAS), et cetera. These well-established metrics allow to underwrite the opportunity and risk profile of a recurring revenue firm with precision, at least at later maturity stages. Thus, why would founders give away equity when they are producing very lucrative gross margins and durable customer relationships – and can prove their business health by industry-wide accepted metrics? Well, because traditional banks and lenders don’t have the underwriting tech in place, lack the understanding of asset-light software business models and underlying metrics. Software firms have had very limited funding options to invest in their growth, typically constrained to angels, revenue-based finance providers or merchant cash advances, or venture debt lenders.
This situation is changing, fast. Emerging fintech companies born in the SaaS economy and with a deep understanding of SaaS business models have entered the game by treating the annual recurring revenues as a new asset class, similarly to a fixed income product, and creating a new investment opportunity via recurring revenue securitization. In a nutshell, they allow SaaS firms, and in theory any firm generating recurring revenue streams, to sell their future ARR bookings at a small discount. The interesting thing is that most SaaS companies do this already by offering their annual subscription prices for a discount, however, most leave quite a lot of money on the table for receiving the fees up front, as discounts typically range from 20-35 percent.