SaaS investing has been on fire the past decade and the returns have been gushing in, with IPOs like Datadog, direct listings like Slack and acquisitions like Qualtrics (which is now being spun back out) creating billions of wealth and VC returns. Dozens more SaaS startups are on deck to head toward their exits in the same way, and many VC funds — particularly those with deep portfolios in the SaaS space — are going to perform well.
Yet, the gargantuan returns we are seeing today for SaaS portfolios are unlikely to repeat themselves.
The big threat in the short term is simply price: SaaS investing has gotten a lot more expensive. It may be hard to remember, but just a decade ago the business model of “Software as a Service” was revolutionary. Much in the way that it took years for cloud infrastructure to take hold in corporate IT departments, the idea that one didn’t license software but paid by user or by usage over time was almost heretical.
For VCs willing to make the leap into the space, prices were (relatively) cheap. Investor attention a decade ago was intensely centered on consumer web and mobile, driven by Facebook’s blockbuster IPO in May 2012 and Twitter’s IPO the following year. While every investor was chasing deals like Snap(chat), the smaller population of investors targeting enterprise SaaS (or even more exotic spaces like, gulp, fintech) got great deals on what would later become the decade’s biggest unicorns.
That supply-constrained world of VC investing into enterprise is long gone. As I and my colleagues have been curating The TechCrunch List of the top first-check writers and lead VCs the past few months, the issue hasn’t been finding enterprise investors, which is by far our most populated category out of 22. It was actually finding VCs who specialize in consumer apps.
Prices have unsurprisingly moved in tandem. What might have been a $4 million series A round at $16 million pre has become the new $20 million on $80 million — and that’s considered by some founders to be cheap! Those valuations are driven by extraordinary valuations on Wall Street, where companies like Datadog have a revenue multiple of 64x — and that’s publicly traded!
Higher prices obviously make it tougher to secure excellent investment returns. Maybe exit valuations will increase in the coming decade (more customers, more people using online services, etc. can expand the TAM). Maybe. Far more likely is that lucrative bets made a decade ago are a red herring for the investment returns expected going forward in this sector.
SaaS securitization is the medium- to long-term disruptor of SaaS VC returns
High valuations are hitting the SaaS investment market hard right now, but that’s just a short-term disruptor — ultimately, if prices are high, some investors will leave the market or head to other sectors to reap returns, and prices will normalize at a more appropriate market price. That’s just Finance 101.
The more innovative pattern, and one that entails far more risk to SaaS investors longer term, is something that has been broadly called “SaaS securitization.”
Let’s unpack that term, because there are a couple of pathways that the market could develop, and which path the market goes will determine how much damage securitization will cause VC investors.
All startups, whether a dog food delivery app or an enterprise SaaS application, can already take on debt today to fund operations. Many startups, particularly startups with recurring revenue like SaaS startups, choose this option as part of a balanced corporate finance strategy. As revenues grow and get more consistent, debt becomes more plentifully available and cheaper, and so we often see venture growth rounds with more and more debt added into the mix as companies mature.
That debt is attached to the underling company: If something goes wrong, a bank can seize a business and sell off everything from its intellectual property to the desk chairs to get a return. But fundamentally, that debt today isn’t really connected to the revenue model underlying the startup itself. That limits the amount of debt that a startup can take on, as well as how early it can buy debt.
SaaS securitization comes in two parts to make this market much more efficient. The first part is to underwrite loans that are directly tied to a startup’s recurring revenues. Imagine scoring debt risk knowing the likelihood of a specific customer churning or that an enterprise client will have revenue expansion over time. A bank could offer a startup a loan facility based on the actual SaaS metrics of that business. Grow fast with great customers and low churn, and a startup could have access to even more debt capital than with traditional loans. Better underwriting could “prove” that a startup is lower risk than it appeared under simpler financial models.
More importantly, that debt could be “asset-backed” — if the company fails to pay back its loan, a bank could theoretically seize the underlying revenues backing that debt and perhaps even sell it to a market competitor. So if you are a SaaS payroll provider who bought debt and later defaulted, the bank could take, say, your 2018 SMB customer cohort revenues (and presumably the customers themselves) and turn that over to another SaaS payroll provider.
That’s part one. Part two is to take all those individual loans and package them together into a security (that’s where the “securitization” comes from). Imagine being an investor who believes that the world is going to digitize payroll. Maybe you don’t know which of the 30 SaaS providers on the market are going to win. Rather than trying your luck at the VC lottery, you could instead buy “2018 SaaS payroll debt” securities, which would give you exposure to this market that’s safer, if without the sort of exponential upside typical of VC investments. You could imagine grouping debt by market sector, or by customer type, or by geography, or by some other characteristic.
For founders, this new debt product is a godsend. Instead of taking dilutive equity investments from VCs to grow, they could tap this advanced debt market for cheaper capital. Suddenly, founders have both more leverage in their fundraises, and also just need to raise less capital period. Maybe they skip a venture round, space their rounds further apart or just raise less capital each time. Less demand for SaaS investment means VCs will have to compete over smaller slices of these companies.
It actually gets worse than that for VCs though, and this is where the real disruption to the return model for VC will usher in this decade. See, it’s precisely the best SaaS companies that will have access to the most debt. The SaaS companies that grow the fastest, that get their entire contract value upfront, that have the best economics — they are going to receive the best underwriting. Which means that the most valuable startups are also the ones that will presumably need the least amount of capital.
It’s frankly a classic version of a lemons market — the best startups will need limited equity capital since they have the best debt options available to them, which means that any startup fundraising will almost by definition be slower growing, lower performance, and therefore, a far worse VC investment.
We haven’t seen these models before, mostly because SaaS just wasn’t a big enough category. Securitization requires huge scale, like the trillions of dollars in mortgages or corporate debt. SaaS has now grown to an effectively large size where underwriting can be done and enough investors may be interested in holding a piece.
These ideas have percolated a bit over the last six months. Alex Danco, who was formerly at Social Capital and is now at Shopify, wrote an analysis on his blog a few months ago called “Debt is Coming” that brought some notable attention to this issue. There have also been some interesting tweet threads about the topic from industry luminaries.
Most of that was just talk though. From what I hear through the grapevine however, there are at least 2-3 startups being built in this space that have teams and funding (equity funding, sadly!) in place. There is also capital ready for underwriting these models already available, with banks bullish as they seek new profitable assets in a returns-constrained world.
These companies aren’t simple to build. They need robust data science and financial underwriting models to be able to price debt effectively. They need to build up the policy, legal and regulatory structures for these debt instruments to not only hold up to scrutiny in a board meeting, but also to pass muster with government agencies that regulate these instruments. Plus, they will need to sell external investors on the premise to have them actually buy securitized debt into what are, for all intents and purposes, still high-risk startups.
Yet, that’s precisely the upshot of medium-term threats. Those problems are real, but not insurmountable. In one decade, we went from buying licenses for software to paying monthly for services and in the process, revolutionized the hundreds of billions spent on enterprise IT. There is no reason why in another decade, SaaS founders with the metrics to prove it shouldn’t have access to less dilutive capital through significantly more sophisticated debt underwriting. That’s going to be a boon for their own returns, but a huge challenge for VC firms that have been doubling down on SaaS.