Key Points:
- Revenue-based finance plays an increasingly important role in the financing mix of tech firms with recurring revenues. The market for revenue-based finance is expected to grow with a CAGR of 60%+ over the next five years.
- Revenue-based finance is superior in terms of flexibility and simplicity as it enables tech companies to monetize streams of recurring revenues. Revenue-based finance is set to become the core financing instrument for tech firms.
- The tech credit market will be dominated by specialised tech lending firms, such as @Round2, having a deep understanding of tech and software. As there are limited tangible assets that can be used as traditional loan collateral, banks are likely to play only a minor role.
- Tech credit is a new asset class and is set to become one of the largest lending markets given digitalisation.
Digitization is progressing rapidly
The digitization of the European economies is progressing rapidly. Software is at the core of digitization and thus a key factor for our present and future economies. The merger between software development and distribution with cloud computing a bit more than 10 years ago led to the formation of the software-as-a-service („SaaS“) business model. Today SaaS is the dominant business model for all software firms across all verticals. Just think of how you installed and paid for Microsoft Office five years ago and how you do it today.
Software is mainstream and maturing
When cloud computing and SaaS were still new it was natural that the emerging companies would be funded by venture capital only. The market was just emerging, and the risks were unclear. However, today more than 10 years later SaaS is a proven business model and software is fundamental to our economies. The market, the technology and the companies are maturing and the operational risks of running a software business are well understood and thus declining. Recurring revenues, which make cash flows stable and predictable, are a key feature of the business model.
As the market matures and the risks decline the nature of the financing instruments used for funding the growth of software firms is changing. Instead of using venture capital as the exclusive form of funding, today entrepreneurs running software firms are becoming very proficient in managing their cashflows and also increasingly knowledgeable about funding options. They are actively looking for alternative and less-dilutive forms of funding.
These twin forces of declining risks, i.e. a better understanding of software and related business models coupled with the increased sophistication of software entrepreneurs with regards to managing cash-flows and understanding financing options, leads to the emergence of an alternative debt market for software companies.
The tech credit market will be dominated by private debt providers using revenue-based finance
Technology credit is becoming a separate asset class. Software is an intangible asset and does not lend itself to the kind of tangible collateral banks require. Thus, banks will continue to play only a minor role in the market for tech credit. Instead, the market will be dominated by private debt firms understanding the rules and nature of tech and software and being able to generate superior riskadjusted returns.
The amortizing loan developed in the industrial age and applied by traditional venture debt firms, also to tech companies, is not the appropriate financial instrument. It is not making use of the specific advantages of software firms – such as recurring revenues and high cash conversion – and its inflexibility in terms of amortizing schedules and maturity can sometimes even cause harm to the borrowers if not applied diligently.
Instead, revenue-based finance is the appropriate financial instrument for this market. The expansion of revenue-based finance is itself supported by tech which makes its use ever more efficient. Linking repayment and royalty payments to recurring revenue is the most simple, secure and flexible way to monetize recurring revenues for both, the lender and the borrower. It works because of the specific features of the SaaS business model:
- Recurring revenues with stable and predictable cash-flows
- High cash conversion due to high gross profit margin and low working capital and capex needs
Round2 is leading the revenue-based finance market in Europe. To date it has been financing 23 digital growth companies across seven jurisdictions in Europe and is expanding rapidly.
