Software as a service startups are popping up everywhere these days, and for good reason. The monthly recurring revenue business model is certainly desirable because it is predictable and profitable. The problem with a successful software as a service company becomes financing growth. Generally with software as a service there is no upfront, one time cost to get started. Instead, many times a company will offer the first few months for free as an incentive to get a customer to try the service. The problem is that in general most of the costs for the company are incurred when they sign up a new customer. For example, it may cost you $100 to acquire a customer who then pays $20 a month for your service. This is a great business if you can keep the average customer for longer than 5 months, but it causes some real cash flow issues. Each time you sign up a new customer, you need to come up with $80 initially to fund the difference between the acquisition costs and the first month’s revenue. So how do you finance a business like this? At some point you will be able to raise investment, but probably not right away. You need to show growth and sales first. So here are 3 realistic ways to fund this type of startup:
1. Microloans – Traditional banks are scared of software, they are scared of this type of recurring revenue business model in the early days of the business because every time you grow you need more cash. That scares the traditional bank, but there is another option. The SBA has a program called the Microloan Program. There are SBA microlenders all around the country who work to fill a lending gap. They lend where traditional banks do not. You won’t be able to run forever on a microloan, but it may help you get closer to securing that large investment or line of credit from the bank. Microloans are typically between $1,000 and $50,000. Here is a listing of all the SBA Microlenders in the United States.
2. Credit Cards – In a software as a service business you will always need additional funding if you want to grow. There is no magic bullet. Even if you raise some angel investment you will need to come back for more time and time again if you want to grow. A majority of your costs are up front. Over the long term each new customer will be profitable, but that breakeven point might not be for 6 months or longer. Sometimes this problem may drive you to fund your growth with credit cards. This is not ideal, but it can work. Just like a microloan, a credit card won’t solve all of your financing problems, but it can help you kick the can down the road. The problem is, if you go to an investor and you have very little in sales, you are going to have to give up a huge percentage of ownership. You need to find ways to increase your sales so that you can demand a higher valuation when it comes time to meet with investors. Yes it is risky to get yourself too deep in debt growing the business and then find out you can’t secure an investor, but generally you will be able to find investment for a growing software as a service business, the only question is the valuation. How much of the business will you give away.
3. Alternative Financing – Lastly, there are some interesting new ways to finance businesses that charge their customers via PayPal or credit cards. New alternative lenders are actually taking your PayPal data or your credit card/bank account data to determine how much they are willing to lend to you. There are two examples of this type of financing. Kabbage.com uses your PayPal data, social network data, and Amazon or eBay seller data to determine your credit-worthiness and how much you are able to borrow. Similarly, OnDeck Capital uses your cash flow data from your bank account to determine if they are willing to lend and how much they are willing to lend. Then they actually pull small payments back from you on a daily basis. They realized that it could be hard to come up with a 1 time monthly payment for your loan, so they pull on a more regular basis. This reduces their risk and a lender. Now both Kabbage and OnDeck come at a price. This is certainly not the cheapest way to fund your business, but it can help you grow without giving away the entire company to an investor.
All 3 options here are a bit more realistic than walking into your local bank and asking for a $100,000 line of credit to help grow the business. That is very rare for a software company and even more rare for a startup. So consider these financing options as stepping stones until you get to that $500,000 in annual recurring sales. At that point you will be able to secure an investor without giving away all of your equity. Good luck!