August 24, 2022

How to design an efficient capital stack for recurring revenue businesses

How to design an efficient capital stack for recurring revenue businesses
Founders have several options to raise capital at their disposal, like equity financing, venture debt, alternative financing. Each method has its own set of benefits and pitfalls. The choice of which type of financing to use should depend on the stage of your growth journey, end  use of capital and the right balance in your capital stack.
As more and more businesses have started adopting the subscription model, recurring revenue streams need to be seen in a different light. Startups no longer need to just rely on VC funding for their capital requirements. They need to realise the cost of capital associated with equity financing and learn about the other methods available at their disposal. In this article we want to discuss the different financing  options for recurring revenue companies and how to design an efficient capital stack that works best for them.

Installation Period (Requires Speculative Capital)

During the early stages of a company, their core value proposition is  exciting but market opportunities are generally unknown. Speculative  investments from VCs with no exact ROI are important for founders who  are looking to build something out of nothing. This financing is  generally used for research and development or for companies prior to  achieving product-market fit.
These early investors are willing to take risk with a more open  minded timeline as the potential upside of the equity investment can be  huge (higher risk with higher returns). For founders this equity  financing can be life giving but the dilution can be a potential death  sentence. Founders can end up asking themselves, did I dilute too much  or if the dilution was necessary at all?

Deployment Period (Requires Production Capital)

Once companies have achieved product-market fit and generate recurring revenue streams from their clients, multiple financing options  can potentially open up for them. Equity financing continues to remain a powerful tool especially for research and development, expanding into new geographies or where the break even period is longer (say c. 24 months or more).
Here the cost of equity capital becomes more prominent. Just the mere  process can be time consuming and stressful for founders (sometimes taking over 6 months) and diverts their attention away from actually  running their business. Not to mention the dilution which would be done at a much higher valuation then their previous funding rounds.
Debt has traditionally been the answer to dilution, but it comes with its own set of pitfalls. This sort of financing allows founders to retain ownership of their company, however incase of delay in repayments there can be financial obligations on the company and restrictive  operational and financial covenants.
Not to mention this financing method is only available for asset heavy companies that can put up significant collateral.

Subscriptions as an asset class

There are alternative financing options available to companies that can leverage their subscriptions to raise capital. In this case founders  don’t need to dilute their equity to raise growth capital and the  process is tech driven and extremely fast. Companies can raise the  Lifetime Value (LTV) of their existing customers upfront.
Recurring revenue is not only predictable, it’s also much lower-risk than people initially thought it was. Companies are more likely to pay  their software maintenance of subscription fees before any interest payments as that’s pertinent for their business operations. This  relative stability and maturity of the recurring revenues makes it akin to a fixed income like yielding asset profile for an investor.
Subscription based financing is a capital influx method that uses the company’s monthly or quarterly paying subscriptions to raise upfront growth capital. Organizations pay back their investors as their clients pay them which ensures flexibility and freedom. It is one of the most  founder friendly ways to raise capital as there is no dilution to your shareholding nor are there any restrictive financial covenants.
Subscription based financing works by valuing the smallest atomic unit (i.e. the contract or a subscription) and should be an integral part of the capital stack for subscription companies along with equity and debt.

The bottom line

It’s a no brainer that companies with recurring revenues should have subscription based financing in their capital stack.
Subscription based financing works complementary to equity financing as it enables founders and shareholders (including some of the existing VC investors in the Company) to dilute less in future rounds and raise growth capital through their subscriptions.
Having a strong equity capitalization means you can add a bit of leverage by trading recurring revenue streams, with focus and confidence. While trading recurring revenue streams means that Founders and shareholders can end up diluting 4-5% lower equity in each round which can have significant compounding effects to one’s ownership over a  period of time. An efficient capital structure ensures companies don’t dilute too much equity or take on too much restrictive debt.
This article was written by Eklavya Gupta and first published on Times of India.