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December 8, 2020

Software as a Service (“SaaS”) Lending is Going to Become Mainstream

It’s only a matter of time before SaaS lending enters mainstream ABL.  Lending to SaaS, which stands for Software as a Service, differs from traditional software in that it is deployed and made accessible to users over the internet (or in the “Cloud”), and is going to be the next ABL battleground.  Today it remains a niche lending vertical conducted mostly by tech-focused banks and nonbank credit funds.  However, this is going to change meaningfully as the SaaS industry continues to mature. There are an estimated 10,000 private SaaS companies, the vast majority of which are early stage, generating less than $3 million in annual revenue.  To put this in perspective, companies such as the wildly popular Zoom and workforce tool Slack utilize SaaS models.  The U.S. economy is well into a transformational period where many business tools are moving to the cloud.

The ABL world needs to adapt to this new vertical as the ongoing rise of the SaaS industry isn’t just anecdotal.  According to Gartner, worldwide market revenues from SaaS companies could hit $151 billion by 2022.  Eighty percent of businesses already use at least one SaaS application. These trends are only going to grow exponentially as most businesses transition from traditional, on-premise software to the Cloud.  The industry is going to experience growth, maturation and more sizeable businesses that portend great lending clients.  Interestingly, most banks classify SaaS in their ABL groups with the argument being that the recurring contracts are tantamount to a receivables-based deal.

Many of the typical ABL underwriting principles apply – multi-year contracts, customer concentration, end-customers, margins, liquidity and wind-down.  The seminal difference is understanding software contract values as opposed to hard asset values, which is still foreign to most ABLs. How would you like to lend to a mission-critical software company with 100+ clients, multi-year contracts, 80% margins and no concentration?  However, deferred revenue is often created as many, but not all, contracts actually pay upfront, which is a real concern as the service still needs to be provided. The lending metrics are also wildly different from traditional ABL – try a multiple of Monthly Recurring Revenue (“MRR”) rather than percent of AR.

When structured properly, mission-critical software provides for very attractive, low-risk opportunities even with meaningful leverage.  These businesses are already getting really aggressive leverage in the market.  Small, bootstrapped SaaS businesses are typically getting 5 to 6x MRR and bigger, PE-backed SaaS businesses are getting much higher multiples. The larger SaaS businesses truly do get treated differently given the size, scale and backing which allows them to support unheard of leverage, even for an ABL deal.  These business have strong, multi-year contracts and in a wind-down scenario these businesses should generate cash as a maintenance support is required to service existing customers.

Try winding down a SaaS business compared to an old-line manufacturer with customer concentration and aged trade.  No driving 100 miles outside of a metropolitan city to liquidate M&E, converting WIP to finished goods and dealing with unions.  Unlike many fixed-cost businesses, a good SaaS business can become cash generative overnight in a wind down by cutting out sales and marketing. What this might do is spur a new tech-oriented workout group rather than the traditional folks who are more comfortable in a tier 1 auto supplier plant than a data center.  The same principles also apply – wind downs and liquidations –but instead of a landlord waiver to get equipment or inventory it will be an Amazon Web Services waiver to keep lights on in the Cloud.

Rest assured, this market has been red hot for the past ten years, but it has not been mainstream.  The proliferation of SaaS businesses, strong lender-static pools and industry maturation is catching the attention of mainstream lenders, both bank and non-bank, SG Credit included.  Lending to SaaS has always been a hallmark of SG Credit and SaaS diversification provided a safe harbor during the COVID shutdown. As the industry continues to mature, the lending market is going to migrate from tech-focused lenders into mainstream ABL.

Today,  the larger banks in this space classify SaaS lending under ABL.  These groups are first-movers, play upmarket in the bank SaaS market by partnering mostly with brand-name private equity funds.  The market leaders operate within their own tech finance verticals within larger ABL umbrellas, meaning, each has its own dedicated underwriting, credit and portfolio management groups.  These groups need to operate independently as there are a number of clear and other metrics to consider in SaaS finance that are different than traditional ABL.  The underlying businesses at true private scale require significant industry and market diligence to determine obsolescence and other elements of technology risk, among other things, so in that sense it is quite different from traditional ABL.

To contrast, the large sponsor-focused SaaS lenders banks such as Bridge Bank, Sterling National, Signature Bank NY, Stifel, CIBC, Avid, PacWest (formerly Square 1), are firmly ensconced in the lower end of the middle market.  These banks typically work with venture-backed companies as opposed to private-equity backed, which varies greatly from the large banks.  Silicon Valley Bank deserves its own mention as many of its alumni went on to start the tech lending groups at the aforementioned banks.  Most of these banks primarily focus on SaaS companies with some type of VC or institutional backing, unlike many of the non-bank lenders such as SG Credit, Runway Growth and Accel-KKR, which have a strong focus on financing bootstrapped or earlier stage SaaS businesses to provide a financing bridge to a bank, significant equity round or acquisition.

As we sit here today, there is significant competition in several market segments – small bootstrapped to large sponsor-backed.  Competition should change as the SaaS market continues to grow, driven by companies transitioning to the Cloud. Banks are taking notice of this shift and there is a reason that SaaS has been housed in ABL groups.  This trend should continue and we are in the early innings of what should be a multi-decade industry expansion.  We are all going to be spectators in watching this industry growth transform the tech-lending landscape as mainstream ABLs start to venture into SaaS lending.

Link to article here.