Multi-year contract costs, why working capital can beat cash, and how to blend capital sources, from a lender who has underwritten $250M
Kevin Houston · Founderpath
Published September 1, 2022We’re big on learning from mistakes. We’ve seen (and made) quite a few ourselves.
Our head of Finance, Kevin Houston, shares the top 4 capital allocation mistakes SaaS founders make, and what you can do instead.
In 20 minutes you’ll learn:
- The hidden costs of overusing multi-year contracts
- Why Net working capital is actually better than cash
- How to use multiple sources of capital to build your balance sheet
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Kevin Houston explains capital-allocation mistakes SaaS founders can avoid by understanding contract economics, receivables, liabilities, investment returns, and working capital.
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“capital on your balance sheet as a SAS founder so let's get into that okay so lesson one the downside of the multi-year contract so uh this may resonate with some of you um the multi-year contract is basically you offer a discount for a multi-year relationship with a SAS customer collect all the cash up front uh but what it what it effectively does is it”
“basically of an automatic ndr metric built into your contract structure I think gross margins who who's felt the the pain of inflation over the last little bit you can actually you can actually handle an increasing cost of goods sold because you're collecting more cash over the term of those three years and you're not as susceptible to margin erosion so long story short the key takeaways here are the multi-year contract could”
“lesson three why Network capital is good for your health your balance sheet health so let's start with a story here so who here has heard of commercial paper it is a product used by public companies it's an unsecured debt product that rolls over every 30 days it's cheap it's flexible it's unsecured it's a great product”
“marketing channel and this month you get a dollar fifty back so this is an incredible metric you should use debt for this because it's predictable it's short term and know what use credit cards use short-term debt that's totally fine this is this is a great use of of debt uh it's predictable and if you use equity you're just making your investors rich as a Founder you should make yourself rich”
“you're not you it's not debt or Equity it's debt and equity um manage risk cross obviously try and try not to if anything go longer duration on your capital and shorter duration on your use of proceeds not the other way around and create buffer in your plan part of the value of your business is the option set that you have if you are so constrained because you've spent all your money that you don't have”
“Let’s compare these 2 contracts Comparison Contract 1 Contract 2 Average ACV $50,000 $50,000 Discount 10% N/A Year 1 CF $135,000 $40,000 Year 1 MRR $3,750 $3,333 Year 2 CF $0 $50,000 Year 2 MRR $3,750 $4,167 Year 3 CF $0 $60,000 Year 3 MRR $3,750 $5,000 Which contract is better for (✔): Contract 1 Contract 2 Cash flow day 1 Total cash collected MRR Growth Net Dollar Retention Gross Margins”
“Lesson 1 Key Takeaways Multi-year contracts may help in early days but transition away from them as soon as possible TAKEAWAY 1 TAKEAWAY 2 TAKEAWAY 3 Building in automatic upselling through the contract itself is an Net Dollar Retention cheat code Cash flow is your most valuable asset, maximize it to generate true cash profits”
“Lesson 2 Key Takeaways Ensure customers ability to pay - stay on top of news for your largest customers TAKEAWAY 1 TAKEAWAY 2 TAKEAWAY 3 Instill a Close and Collect culture on your sales team Be Proactive - don’t wait to reach out for payment”
“NWC Runway = Net Working Capital / Last 3 month average Burn What Can We Do With Net Working Capital? Calculate your runway Why not just use cash?”
“A Mental Model for Capital Raising Credit Cards (<1 month) Marketing Spend Short Term Debt (<12 months) Other Go-To-Market (sales hires, SEO, etc.) Long Term Debt (>12 months) Equity / Retained Earnings* Product & Engineering Capital Product Duration Use of Proceeds Duration (months) As a SaaS founder, you should use a combination of capital sources so that you can invest across your organization and manage the risk of the products used. It depends on your use of proceeds: *Retained Earnings are net cash flows produced from current operations. 60+ 0 1 12 24 36 48 Duration (months)”
Video
4 Capital Allocation Mistakes Smart SaaS Founders Avoid - Slide Deck
Kevin House is the founder of Stealth Startup which is an intersections of SaaS, finance and growth. Previously he has been CFO of Thentia and Head of Finance for FounderPath. His interests have taken the forms of venture debt investor, CFO, advisor, and founder. Personally, he is a husband, father to two boys, and a fan of March Madness, the Toronto Raptors and sci-fi.
Adam Baker · Dealpad
Andre Cvijovic · Referrizer
Ari Salafia · Taxtaker
Armando Biondi · Breadcrumbs
Becca Kay · Dingus and Zazzy
Ben Carpel · Galleon
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Founder500 Sept 2022 Kevin Houston Head of Finance, Founderpath 4 Capital Allocation Mistakes Smart SaaS Founders Avoid … lessons I’ve learned from deploying $250m to SaaS founders over the past 5 years
My Quick Background Run finance and underwriting at Founderpath, joined as 1st finance hire Underwritten $250 million of SaaS debt to 190 SaaS companies over last 5 years Raised over $150 million from credit funds and banks
Over the next 20 minutes I’m going to show you lessons I’ve learned underwriting $250m+ SaaS deals LESSONS 1-2 LESSON 3-4 Overuse multi-year contracts (and what’s better) Let Receivables Get Delinquent Ignore Net working capital (plus why it’s better than cash) Mismatching sources and uses of capital
Lesson 1: The Downside of the Multi-Year Contract
Story Time - Cash in Bank vs. Cash Flow Hardware + SaaS Company
Which Contract is Better? Both contracts have average ACV of $50K
Which Contract is Better? Both contracts have average ACV of $50K
Let’s compare these 2 contracts Comparison Contract 1 Contract 2 Average ACV $50,000 $50,000 Discount 10% N/A Year 1 CF $135,000 $40,000 Year 1 MRR $3,750 $3,333 Year 2 CF $0 $50,000 Year 2 MRR $3,750 $4,167 Year 3 CF $0 $60,000 Year 3 MRR $3,750 $5,000 Which contract is better for (✔): Contract 1 Contract 2 Cash flow day 1 Total cash collected MRR Growth Net Dollar Retention Gross Margins
Comparison Contract 1 Contract 2 Average ACV $50,000 $50,000 Discount 10% N/A Year 1 CF $135,000 $40,000 Year 1 MRR $3,750 $3,333 Year 2 CF $0 $50,000 Year 2 MRR $3,750 $4,167 Year 3 CF $0 $60,000 Year 3 MRR $3,750 $5,000 Which contract is better for (✔): Contract 1 Contract 2 Cash flow day 1 ✔ Total cash collected ✔ MRR Growth ✔ Net Dollar Retention ✔ Gross Margins ✔ Let’s compare these 2 contracts
Lesson 1 Key Takeaways Multi-year contracts may help in early days but transition away from them as soon as possible TAKEAWAY 1 TAKEAWAY 2 TAKEAWAY 3 Building in automatic upselling through the contract itself is an Net Dollar Retention cheat code Cash flow is your most valuable asset, maximize it to generate true cash profits
Lesson 2: Bad Accounts Receivable and What to Do About It
Example Company Metrics Metric Value ARR $1,400,000 Y/Y Growth Rate 53% Cash Flow Margin 14% Rule of 40 67%
Can You Really Count Customer Revenue Committed But Not Paid For 90+ Days?
Which Happens to These Metrics: Starting Point (⇧ / ⇩) ARR $1.4M Growth Rate 53% Cash Flow Margin 14% Rule of 40 67% Can You Really Count Customer Revenue Committed But Not Paid For 90+ Days?
Answers Which Happens to These Metrics: Starting Point (⇧ / ⇩) ARR $1.4M ⇩ Growth Rate 53% ⇩ Cash Flow Margin 14% ⇩ Rule of 40 67% ⇩
Lesson 2 Key Takeaways Ensure customers ability to pay - stay on top of news for your largest customers TAKEAWAY 1 TAKEAWAY 2 TAKEAWAY 3 Instill a Close and Collect culture on your sales team Be Proactive - don’t wait to reach out for payment
Lesson 3: Why Net Working Capital is Good for Your (Balance Sheet) Health
Remember Lehman’s Commercial Paper Problem? Commercial Paper Demise Total Commercial Paper Outstanding, USD Billions
What is Net Working Capital? Net Working Capital = Current Assets - Current Liabilities Current Assets Includes Current Liabilities Includes Cash Accounts Receivable (under 90 days) Inventory - I remove this unless it’s high margin Prepaid Expenses - I remove this as it doesn’t convert to cash Accounts Payables Accrued Expenses Credit Cards Short Term Debt Deferred Revenue - I remove this for high margin SaaS (65%+ Gross Margins)
NWC Runway = Net Working Capital / Last 3 month average Burn What Can We Do With Net Working Capital? Calculate your runway Why not just use cash?
Cash is not king. Net working capital is. Raising Debt With < 12 Month Maturity Raising Debt With > 12 Month Maturity Cash Working Capital Long Term Liabilities Current Liabilities Current Assets Current Assets Current Liabilities Long Term Liabilities (>12) Working Capital
Lesson 3 Key Takeaways Look at both cash and net working capital when thinking about your Runway TAKEAWAY 1 TAKEAWAY 2 TAKEAWAY 3 Be careful with short term debts if you are planning to use the capital for growth Spend time with your balance sheet each month to see how accounts are trending
Lesson 4: Match Your Sources and Uses of Capital
Uses of Proceeds Good Use of Debt? Bad Use of Debt? Marketing Program with a Return On Ad Spend (ROAS) of 1.5x
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? X Short term debt is a great option Marketing Program with a Return On Ad Spend (ROAS) of 1.5x
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? Cash is tight and you are worried about next payroll X Short term debt is a great option Marketing Program with a Return On Ad Spend (ROAS) of 1.5x
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? Cash is tight and you are worried about next payroll X Short term debt is a great option X Equity capital is best here Marketing Program with a Return On Ad Spend (ROAS) of 1.5x
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? Cash is tight and you are worried about next payroll X Short term debt is a great option X Equity capital is best here Marketing Program with a Return On Ad Spend (ROAS) of 1.5x Hire a sales rep with a ramp time of 6 months that can reliably produce $500K ARR / year
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? Cash is tight and you are worried about next payroll X Short term debt is a great option X Equity capital is best here X Long term debt would be better Marketing Program with a Return On Ad Spend (ROAS) of 1.5x Hire a sales rep with a ramp time of 6 months that can reliably produce $500K ARR / year
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? Cash is tight and you are worried about next payroll X Short term debt is a great option X Equity capital is best here X Long term debt would be better Marketing Program with a Return On Ad Spend (ROAS) of 1.5x Hire a sales rep with a ramp time of 6 months that can reliably produce $500K ARR / year An Engineer hire to work on a new complementary product
Uses of Proceeds Answers Good Use of Debt? Bad Use of Debt? Cash is tight and you are worried about next payroll X Short term debt is a great option X Equity capital is best here X Long term debt would be better Marketing Program with a Return On Ad Spend (ROAS) of 1.5x Hire a sales rep with a ramp time of 6 months that can reliably produce $500K ARR / year An Engineer hire to work on a new complementary product X 48+ month debt, equity, or profits best for this X 48+ month debt, equity, or profits best for this
A Mental Model for Capital Raising Credit Cards (<1 month) Marketing Spend Short Term Debt (<12 months) Other Go-To-Market (sales hires, SEO, etc.) Long Term Debt (>12 months) Equity / Retained Earnings* Product & Engineering Capital Product Duration Use of Proceeds Duration (months) As a SaaS founder, you should use a combination of capital sources so that you can invest across your organization and manage the risk of the products used. It depends on your use of proceeds: *Retained Earnings are net cash flows produced from current operations. 60+ 0 1 12 24 36 48 Duration (months)
Lesson 4 Key Takeaways You can use multiple sources of capital to build your balance sheet TAKEAWAY 1 TAKEAWAY 2 TAKEAWAY 3 Manage risk through your sources and uses of capital Create buffer in your plan to maximize optionality
Key Takeaways 4 MISTAKES AVOID Founders top job is to mitigate risk Bootstrapping requires patience Double down on small experiments to control risk Multi-year contracts Receivables (watch out!) Net working capital Matching capital sources and uses
Over the last 20 minutes I showed you lessons I’ve learned underwriting $250m+ SaaS deals LESSONS 1-2 LESSON 3-4 Downside of multi-year contracts (and what’s better) What to watch for with your receivables Net working capital (and why it’s better than cash) Matching sources and uses of capital
Sept 2022 Kevin Houston Head of Finance, Founderpath