Exploring the Cost of Capital for SaaS Companies – Part IV: Practical Estimates and Actions for the SaaS Cost of Equity
TL;DR: Using a mix of theory and data, we offer a model for estimating the cost of equity capital for growing, private B2B SaaS companies between $1 and $100 million in ARR. An Excel model template to estimate your cost of equity may be downloaded here.
Previously in this series (Parts 1, 2, and 3) we examined the ideas behind the cost of equity for SaaS businesses from an empirical perspective (comparing to public companies and other industries) as well as from a theoretical perspective (using model-driven results to derive estimates). This gave us two estimates:
Formula 1:
Ke(public) = 14.9%
Ke(1)(private) ~ Ke(public) / (1 – (66% – (33% * (ARR[min 1M, max 100M]/100M) )
Formula 2:
Ke(2) = g
Formula 1 estimates the SaaS cost of equity by discounting the historical public Ke for a smaller company being private and of smaller size. Formula 2 estimates the cost of equity as being driven primarily by the growth rate of ARR. Which of these should we use?
Two models: why not use both?
When we are faced with two useful but error-prone estimates, each with different strengths and weaknesses, we don’t always need to choose one or the other. We should be able to use both together usefully, as long as the sources of error in each estimate are not the same (for example, if you estimate someone’s age by height, and again by weight, your errors will tend to be the same as they come from the general size of the person; if you estimated by height and then by number of gray hairs, you’d have different sources of error).
It turns out there’s a scientific consensus that multiple models can often be fruitfully simply averaged together [See Clemen 1983] That doesn’t mean it’s perfect, but it means that on average, we would expect a smaller error by using the simple average of two models rather than one or the other (or some more complicated combination method without good justification).
Therefore, consider taking a simple average of the two formula results. For a given small, private SaaS company, of known ARR and growth rate, this method estimates the equity cost of capital as:
Ke(combined estimate) =
½(g)
+
½( 14.9% / (1 – (66% – (33% * (ARR[min 1M, max 100M]/100M) ) ) ) )
This is a soft recommendation from SaaS Capital; we would caution against using this as the sole method by which to think about your cost of equity. We also caveat that it’s unwise to use this approach for very low or high growth rates (below zero or above 100%), or companies outside the range of $1-100 M in ARR. It’s also unwise to use this approach for companies raising capital for a “pivot” or a new line of business.
But for growing, private SaaS companies inside those ranges, we’ve produced a downloadable template to aid in applying this approach here https://www.saas-capital.com/blog-posts/exploring-the-cost-of-capital-for-saas-companies-part-iv-practical-estimates-and-actions-for-the-saas-cost-of-equity/.
Some examples of estimated Ke
Let’s consider two example SaaS companies: RocketRide Inc., a $10 M ARR company growing at 60% year-over-year, and SlowSoft Inc., a $50 M ARR company growing 10% year-over-year.
Ke(RocketRide) =
½(60%) + ½( 14.9% / (1 – (66% – (33% * $10M/$100M) ) ) )
=
½ 60% + ½ (14.9% / (1 – (66% – 3.3%) ) )
=
½ 60% + ½ (14.9% / 37.3% )
=
½ 60% + ½ 39.9%
=
50.0%
That’s a high Ke by any measure. However, consider what a $10 M ARR SaaS company growing at 60% represents: it’s almost certainly able to raise VC or private equity, able to get profitable if necessary, and likely a ripe acquisition target for strategics threatened by its rapid ascent. It’s still early but RocketRide could IPO in 4 years at this pace. Surpassing $10 M ARR with solid growth is a sort of “Holy Grail” of management teams; selling off shares in a company that is achieving at this level is very expensive capital indeed.
Ke(SlowSoft) =
½(10%)
+
½( 14.9% / (1 – (66% – (33% * $50M/$100M) ) ) )
=
½ 10% + ½ (14.9% / (1 – (66% – 16.5%) ) )
=
½ 10% + ½ (14.9% / (50.5%) )
=
½ 10% + ½ 29.5%
=
19.8%
Consider this much lower Ke and what it represents. SlowSoft is of substantial scale – at $50 M, a SaaS company usually could be quite profitable, and has a ton of strategic options including forming the base of a roll-up play, seeking a massive growth round, or maintaining independence with debt-only financing to juice growth. However, the slow growth at only 10% tends to weigh down the equity prospects here, resulting in a Ke much lower than that of RocketRide.
If the cost of equity is so high, why does anyone raise equity?
Some readers may look at a predicted cost of equity of ~ 50% for a fast-growing SaaS company with skepticism. “That seems much higher than I expected,” you might think, “and if it was really that high, why would anyone raise equity capital in that case?”
Growth rate: if you are growing at 60% like RocketRide in the example above, then it might well make sense to raise equity, even with a 50% cost of equity – to continue to fuel a similar return rate for the existing shareholders or founders, and possibly increase the growth further. Furthermore, because strategic opportunities (like mergers, roll-ups, and IPOs) tend to increase in number and value as SaaS companies increase in size from $1 to $10 to $100 million in ARR, it’s probably worthwhile to continue to raise with a high cost of equity, provided that growth outpaces the cost.
Amount (or “quantum”): Even though, as we show below, the cost of debt is much more knowable (and usually cheaper), the availability of debt is subject to the underwriter’s judgment about a sustainable debt load. Keeping a rocket ship fully fueled might require a lot more cash than a lender is willing to underwrite. That leaves equity – even very expensive equity – as sometimes the best option to fuel a fantastic growth story.
So, as a shorthand rule of thumb: raise equity if and only if
How do I compare the cost of equity to cost of debt?
A term sheet for a loan typically has a clearly stated interest rate (plus, fees should be modeled for an “all-in” cost of debt). But even before you have a term sheet, there are resources you can use to compare.
Spinta Capital has prepared a recent (Summer 2024) study of rates among bank and non-bank lenders to early stage, high-growth companies (they focus on a size range of $10-300 M in revenue). According to that survey, all-in debt costs at midyear ranged from a low of 8% for bankable (typically larger and profitable or venture-backed) companies, to 20% for non-bank debt (typically for the smaller and riskier end of things).
That range of 8% to 20% is a wide one, but it’s also fairly reflective of another truth, namely that debt for a SaaS company is generally going to be much cheaper, by the numbers, than equity. SaaS businesses can uniquely benefit from this pricing disparity because of their highly predictable recurring revenue models and well-understood unit economics. That predictability, and hence the availability of debt funding, is the SaaS entrepreneur’s secret weapon.
However, there’s a catch: the Spinta data also shows the range of maximum Debt-to-ARR levels to be found in the market, generally 0.3x to 1.0x, with an extreme of 1.5x. Only those companies that need a relatively limited amount of capital, generally below 1.0x their current ARR, can rely upon debt alone. As we describe above: the amount of equity capital is often what makes it suitable, despite its princely cost.
(At SaaS Capital, we offer something of a middle path: a line of credit that can increase monthly as MRR grows. Unlike a term loan, an MRR line can serve some of the function of a flexible growth financing round, though it will never match the flexibility of unconstrained cash from a big equity raise.)
What about moments of FOMO and VC animal spirits?
At times (e.g. market-wide in 1997-1999 and 2020-2021, and for a few periods in between for specific markets or technologies), the technology venture world goes into a hype cycle, when aggressive competition for deals and “fear of missing out” drives venture investors to bid up valuations far beyond what arithmetic alone can justify. (To be clear: in Summer 2024, we are not in such a time in the general B2B SaaS market.)
If you find yourself lucky enough to be caught up in a VC bidding war far beyond what this model seems to justify, then consider: the VCs aren’t doing a cost-of-capital spreadsheet that day, and neither should you. At that point, the winning play is to seek the most value-added investor group, optimize your terms around governance, and avoid taking capital in an amount or structure that commits you to an inflexible growth explosion before you are ready. (In particular, avoid “ratchets” and try to reduce liquidation preferences, both of which dramatically limit your options if fortunes turn.)
We won’t dive deep here into the mechanics and game-theory of an equity raise during tight times, when equity investors are skittish. Both sides want to “buy low, sell high” but the company raising capital should (in theory) have a much better sense of the actual likely forward growth rate, and hence, the “true” cost of equity. That can manifest in lower valuations (and higher cost of equity) but more likely just stops deals from occurring, as the VCs are paralyzed by fear of buying in a “market for lemons.”
So, the cost of equity estimation method here is necessarily informed by the average over the longer term: your true cost of equity will be a bit higher when the purse-strings of VCs are tight, and could be dramatically lower when the FOMO is high and the animal spirits run wild. But on average, over time, this method is a sound way to structure thinking about this admittedly sometimes bewildering topic.
Horses for courses – a conclusion
If there’s one thing to take away from this series, it’s this: Use some reasonable method to estimate the “price tag” of the financing dollars you take; “buy” expensive equity dollars for high risk bets when you must; and shop for cheaper debt dollars for predictable performance when you can. Set against that price tag, though, is the suitability in terms of quantum and flexibility; equity is king in this regard, but isn’t always available (and is always more expensive).
The price tag of equity is unknown and can only be guessed at, but we lay out above two very different, yet both rational approaches for estimating the cost of equity, and suggest using them both in concert (as a simple average).
