How to Choose Between Debt vs. Equity Financing as a SaaS Company

That’s because the type of financing that funds a startup is far more than numbers on a spreadsheet. Debt and equity financing each have their benefits and drawbacks, and the choice can significantly impact a company’s operations.

For finance teams and founders in charge of making the decision, it’s vital to understand the details behind the headline numbers.

In this article, we’ll examine both debt and equity financing. We’ll help you determine which is better suited to your company and which is more accessible in different economic climates.

Debt Financing vs. Equity Financing

There is no right or wrong answer between debt financing vs. equity financing. While using debt to fund growth might be a better option for some businesses, others may find equity financing is the way to go.

The key is to understand the differences between the two.

How Economic Conditions Can Influence Financing Choices

Before we discuss equity financing vs. debt financing for SaaS startups, we need to address the ‘elephant in the room’. In challenging economic conditions, equity financing can be difficult to come by. This can be due to high interest rates or economic uncertainty that keeps investors sidelined.

Many SaaS startups may not have a choice between the two right now. With VC funds reluctant to write checks, debt financing may be a more achievable option for companies that can make it work.

Debt allows founders and existing shareholders to maintain control and minimize dilution before the next growth cycle begins.

This situation is constantly changing, and finance teams must manage their model in line with the broader economic environment. For example, after the 2008 financial crisis, debt financing was difficult to access as banks and lenders sought to reduce their exposure to volatile market segments.

Accurate and detailed financial forecasts will help a SaaS startup navigate all these moving parts. Understanding how different financing arrangements are likely to impact performance will help leaders make decisions that give a company its best chance for success.

Pros and Cons of Equity Financing for SaaS Companies

Equity financing is often the first type of SaaS funding that comes to mind when discussing startups. That’s generally because it’s the most widely publicized funding method. We all know the stories of Silicon Valley angels and venture capitalists generating massive returns on unicorns like Uber and Stripe.

While there are some excellent benefits to equity financing, there are downsides, too.

Pros of Equity Financing

No repayment of capital —One of the biggest pros to equity financing is that there is no need to make ongoing debt repayments, allowing founders to funnel the company’s revenue and capital directly into the business.

Advice and network access—Prominent VC funds and angel investors bring more than their checkbooks. Their network and experience can help SaaS startups land new clients and improve their product roadmap or business strategy. This advice can help a business in tangible ways that can significantly benefit the company’s growth trajectory.

Long-term financing—The right equity investors may wait years for a return if there’s a clear roadmap for achieving one. Not only does this reduce the need to make short-term business decisions that detract from a long-term strategy, but it can also provide avenues for securing additional funding from the same investors during later rounds.

Cons of Equity Financing

Dilution—Equity financing dilutes ownership through equity given to new investors. In the event of an eventual acquisition or IPO, founders, and early employees will receive less than if they had taken debt financing.

This dilution can be significant, with one analysis of 30 major SaaS companies showing that the average founder equity at IPO was just 15%. At the bottom end, the founder of DocuSign owned just 1.5% pre-IPO.

Potential cost of financing—This dilution then dovetails into the overall cost. A loan with a total cost (principal plus interest) of $2 million will only ever cost that amount. The potential market cap of a company is the only practical limit on the cost of equity financing. Seed startup capital in the tens of thousands could cost founders millions of dollars in equity value over time.

Possible loss of control—Equity comes with the power to help shape the direction of a company. This can be in the form of soft influence if founders keep majority ownership or direct control if they lose it. In many instances, founders have been sacked from running their own companies.

When Equity Financing is the Right Choice

Equity finance is a clear choice when a company is new and likely unable to secure debt financing. Early-stage startups may have a limited track record and little to no revenue to prove their ability to make ongoing repayments.

At this stage, founders sell the company’s long-term vision rather than its short-term financials. Angel investors and VC funds often build their business models on this long-term view, which may make it more achievable than debt financing.

Equity financing can also be a good choice for companies that are looking to scale and need more than just cash to make it happen. Adding an influential investor or VC fund to the cap table means business expertise and connections that they can’t easily access through regular hiring processes. It also gives the market a strong positive signal that your company might be on to something great.

It’s worth noting that a company needs to view equity financing needs in the context of each funding round. Securing one round of equity financing is great, but finance teams and executives must immediately look to the next round. How long will the new cash last? What milestones will the company need to hit to raise at a higher valuation at the next round? Which SaaS benchmarks should the company use to monitor progress?

A clear and achievable plan should outline how the funding round fits into the company’s broader growth strategy.

Pros and Cons of Debt Financing for SaaS Companies

While debt financing may not be quite as high profile as equity financing in the SaaS sector, it’s really the only type of financing available for many industries. As a more traditional approach to accessing cash, it comes with its own set of pros and cons.

Pros of Debt Financing

Minimal dilution — The key advantage of debt financing is that it doesn’t dilute ownership of the company. Generally speaking, debt doesn’t come with any claim on equity. When a company makes its final debt payment, the relationship ends and the existing business owners keep all their original equity.

Maintain full control—By extension, founders can maintain control over any business funded primarily with debt. As long as the company continues to make the required loan payments, they can continue to lead the company and shape its long-term vision.

Capped financing cost—While borrowing money can be expensive for SaaS startups, the total loan cost is capped.

Cons of Debt Financing

Cash flow impact—For SaaS startups, where cash flow can be uncertain and breakeven can be many years away, debt payments place an extra burden on day-to-day operations.

Increased reporting obligations — Creditors usually need more regular financial reporting than investors. They often expect monthly updates on financial performance, cash balances, and forecasts. This can take a significant amount of time for the finance team to complete.

Reduced flexibility through debt covenants—Debt covenants can have far-reaching consequences for a SaaS startup. Some examples include requirements to maintain a minimum cash balance or to hit certain ARR milestones. If these covenants aren’t adhered to, creditors can potentially call in the total outstanding loan amount.

The details should be well understood so that finance teams can build the financial model to include and assess their impact.

Creditors impact on wind-up value — If the company is sold off or wound down without becoming a financial success, creditors receive payment before shareholders. This can wipe out any residual equity value, even if the company’s assets hold some value.

When Debt Financing Makes Sense

Debt financing for a SaaS company can make a lot of sense if the business has enough cash flow to meet the repayment obligations and debt covenants. This avoids further dilution and maximizes long-term value for existing shareholders.

The market may also dictate when debt financing is the better option, in that sometimes it is the only option. Equity financing is difficult to come by as interest rates have soared. The key to making debt financing work is to have a detailed financial model that projects all the impacts of that debt. That includes modeling the impact of falling foul of debt covenants to gain an understanding of the ‘worst-case scenario.’

Making the Right Financing Choice for Your SaaS Company

To make the right financing choice for your SaaS company, finance, and business leaders need to combine an understanding of the general economic climate, startup funding options, and the company’s future growth prospects.

All of this comes down to data. Understanding the granular detail of each financing option and building that into the financial model while considering various scenarios based on economic and market performance can help clarify which option is likely to be the right one.

And, of course, these decisions will be guided by what’s attainable. While you may decide internally that equity financing is the right way to go, the lack of availability might mean debt financing is all that’s available. That doesn’t have to be a problem as long as decision-makers understand the overall costs and build these into their financial forecasts.

Tools like Mosaic allow finance teams to build complex financial models in minutes, and model an almost unlimited number of scenarios based on different assumptions or growth trajectories. This not only helps with assessing the various options, but also in maximizing capital efficiency when the new cash lands.

Mosaic also creates a centralized source of truth for your entire business, automatically consolidating data from HR, sales, finance, and more, allowing leaders to instantly generate reports and summaries that help support those projections and secure funding or financing. Giving finance teams access to all of the most important financial ratios to analyze a company at their fingertips presents an image of professionalism that investors and creditors want to see.

Making the right financing choice for your company comes down to details. With Mosaic, all those details are available when you need them.