What is Capital Structure? A Guide for High-Growth SaaS

What is Capital Structure?

Capital structure refers to how a company finances its operations and growth through different sources of funds, specifically the use of debt and equity. Debt consists of borrowed money that must be paid back with interest. This can include loans, bonds, and other forms of financial borrowing. For SaaS companies, venture debt is a common example.

Equity, on the other hand, involves raising money by selling shares of the company to investors, who in return gain ownership interests.

The capital structure of a company influences both the financial planning and growth strategy. For example, a company funded heavily by debt will need to focus more on short term cash flow to meet debt payments, while a company funded mainly through equity won’t have this immediate cost pressure.

For SaaS companies, which often experience rapid growth and scaling challenges, a well-planned capital structure is very important. It affects everything from the company’s ability to fund their development roadmap, to the decision-making power of the founders of the company.

Therefore, understanding and managing the balance between a company’s total debt and equity is essential for maintaining the financial health and supporting the strategic goals of the business.

How Capital Structure Impacts Business Growth

A well-planned capital structure, balancing the amount of debt and equity, is necessary for the sustainability and growth of any business. Finding the optimal capital structure can have a significant influence on a company’s financial health and its strategic flexibility.

Debt Financing

Using debt has some major advantages. It allows founders and early shareholders to retain full ownership and control while providing funds to capitalize on growth opportunities. The interest payments on debt are tax-deductible, which can reduce the overall taxable income of a company.

However, a high level of debt increases the company’s financial risk. During economic downturns or slow market periods, a company with substantial debt may struggle with cash flow pressures due to fixed repayment obligations and the interest expenses.

For this reason, companies funded heavily through debt will generally look to balance long term growth objectives with short term cash flow.

It may also be difficult to access debt financing for very new companies without a track record of revenue.

Equity Financing

Equity financing doesn’t require regular repayments, which eases cash flow pressure during volatile periods. This is particularly beneficial for SaaS companies that may see fluctuating revenue, particularly in their early years.

The right equity partners can also help companies access future funding. Having a well-known investor on board allows a company to use this vote of confidence to assist in securing future equity or debt funding.

However, it also dilutes existing ownership and potentially reduces control over company decisions. Companies funded mainly by equity may be prepared to prioritize long term growth over short term profits. There are many high profile examples of very valuable, equity financed companies who make losses for years before turning a profit. They wouldn’t be likely to use this strategy if funded with debt.

SaaS companies also need to consider the cost of capital, and whether the cost of debt in the short term is preferable to the cost of equity capital in the long term. One metric that’s commonly used to assess and monitor funding options is the weighted average cost of capital (WACC).

This metric considers all aspects of a company’s financing arrangements, including preferred stock, total debt, leverage ratio, the mix of debt, and the equity value on the balance sheet.

Unique Considerations for SaaS Companies

The scalability, high growth potential and recurring revenue model of SaaS businesses have a significant influence on their funding decisions. Not only do they need to ensure access to sufficient cash to scale and reach profitability, they need to do it without completely diluting the original shareholders.

SaaS companies also generally require substantial upfront capital to develop a product before it can even be offered to the market. This is a significant difference to say, a service based business, which can launch and sell from day one.

Strategic Financing Options for SaaS

From a strategic perspective, the benefits and drawbacks of equity financing vs. debt financing are relatively clear.

Equity financing is ideal for early-stage companies that need capital but want to avoid long-term debt load on their cash flow. While dilutive, equity investments from venture capitalists or angel investors bring not only funds but often valuable expertise and networks. This can offer substantial strategic benefits over and above the dollars funded.

Debt financing can be suitable for established SaaS companies with stable cash flows. Debt does not dilute ownership, allowing founders and early investors to retain control. However, it requires careful cash management by finance to ensure all obligations are met. Generally, it will also come with increased reporting obligations.

It’s worth noting that there are other, alternative forms of financing for SaaS companies.

One example is convertible notes and SAFEs (Simple Agreement for Future Equity), which are popular among SaaS startups. These instruments act as debt initially but can convert into equity during subsequent funding rounds, often at a discount. This gives companies access to cash now, but allows them to repay the liabilities with equity in the future.

This conversion feature is attractive to investors who are looking for equity upside with the protection of debt. It can also be attractive for founders who want to maximize short term cash flow, and potentially limit the dilution of equity by offering it at a future higher valuation.

Managing Equity and Ownership: Cap Table Essentials

Effective cap table management is a non-negotiable for SaaS companies, particularly as they navigate through multiple rounds of financing. But it’s about more than simply making sure your spreadsheet is kept up to date.

Of course, accurate record keeping is a core component, and there are a variety of software solutions that can help automate and streamline the practical steps.

However, the methodology behind the numbers is equally important. Such as the pricing of options for a company that may be closely held and highly illiquid. Private companies should obtain a 409A valuation to determine the fair market value of their common stock.

Tax considerations are also a major part of efficient cap table management. There are a huge number of regulations and rules that must be followed for stock options and awards, and professional advice is highly recommended to ensure you’re meeting all these obligations correctly.

While all of this needs to be assessed in the current period, cap table management also needs to be forward looking. Every new round of financing will impact the current cap table, and founders and senior leaders need to be very clear on how new money will impact the current shareholders before agreeing to any terms.

As finance professionals, it’s extremely important to set, track, and communicate goals to raise the next round at a company valuation that makes sense for the existing shareholders and prevents unnecessary dilution.

Navigating Economic Volatility

All SaaS companies are likely to encounter economic volatility at some stage in their growth journey. Finance executives need to ensure that the company has sufficient flexibility to navigate these challenges without causing long-term damage.

At the same time, they want to avoid raising funds during times of financial distress, resulting in substantial dilution to existing shareholders. There are several aspects to consider:

Flexible Financing

In some cases, it may be worth considering alternative forms of financing from specialist lenders if economic volatility is causing short term cash problems. For example, accounts receivable financing or revolving credit lines can provide access to smaller amounts of cash that can help see a company through a difficult period without resorting to large scale financing at the wrong time.

Utilizing Analytics for Agile Planning

Regardless of how the cap table and financing is managed strategically, finance teams need the right data analysis tools to make those strategic decisions.

Software like Mosaic provide finance with a consolidated view of every financial aspect of a company, along with comprehensive financial forecasting capabilities, customizable dashboards, advanced metrics and AI-enhanced analysis functions.

Mosaic allows SaaS financial analysts to model different financial scenarios and understand potential impacts on their business which will ultimately impact its capital structure. This capability is invaluable for making informed decisions about when to tap into different financing options, how to adjust spending, and where to allocate resources most effectively.