Even if you’ve never heard the term software as a service (SaaS), you are likely to make use of it on a regular basis. In today’s episode, John Gallagher explains where the concept of SaaS originated from and shares examples of both the consumer elements and the business-to-business elements of it. The SaaS industry is growing with speed, and the company John runs helps founders of software companies to expand their businesses through lending them capital. The company is called Element SaaS Finance, and John explains how their model of lending differs from the traditional venture capital model, and why it offers a much greater degree of sustainability. We also dig into why the company’s interest rates are quite high, why banks generally don’t like to lend money to SaaS companies, the due diligence that John makes sure to do before lending money, competitors to Element SaaS Finance, and one of John’s most important learnings through his years of experience in the space.
Key Points From This Episode:
- The origin of software as a service (SaaS) and the massive scope it has today.
- Consumer elements and business to business elements of Saas, and examples of these.
- Growth that is being experienced in the SaaS industry.
- How John found his way in the world of SaaS.
- Sustainable venture capital versus unsustainable venture capital.
- The aspects of SaaS companies that make them appealing to lend to for certain people.
- Why banks typically don’t want to lend to SaaS companies.
- What a warrant is in the context of lending, and why John’s company doesn’t them on.
- Reasons that John’s company places quite high interest rates on their loans.
- Due diligence that John will do before lending money to a SaaS company.
- The approach that John takes to dealing with clients.
- Competitors to John’s company, and the similarities and differences in how those companies work.
- Getting to know the people who you are lending to is vital.
- How, on average, John divides his time between current clients and new ones.
[0:00:18.5] JM: Hi, I’m Jenny Merchant, co-founder of PitchBoard and welcome to The Pitch Podcast. We’re here to have thoughtful discussions with forward-thinking managers who are taking unique approaches to professionally investing capital. Through these conversations, we hope to introduce you to new ideas and strategies that will help you better manage your own portfolios.
Before we begin, we want to remind our listeners that everything in this podcast is for educational purposes only. Nothing here is tax, legal or investment advice. We don’t endorse any products, services or opinions made by our speakers. Some statements in this podcast may contain forward-looking projections. These projections do not guarantee future performance and any past performance does not guarantee a future result. Finally, nothing in this podcast is an offer to buy or sell securities. Speak to your own advisor before making any financial decision.
[0:01:05.6] AH: Hi, this is Andrew from PitchBoard. I chatted with John Gallagher of Element Finance, a fund that lends to software as a service companies. He discusses why banks aren’t keen on lending to these firms and why he’s happy to fill the void. Take a listen, I think you’ll enjoy the conversation that follows.
John, Welcome to the podcast, it’s great to have you today.
[0:01:23.8] JG: Thanks Andrew, it’s great to talk to you.
[0:01:26.2] AH: I think it’s not maybe a bad idea to start by just maybe explaining to listeners what software as a service is because I know, you know, when I thought about it, the first thing I thought about was that it was mainly things like antivirus software or something like that and then when I googled it, I realized it was more like cloud computing and stuff like that. Do you want to just give us a sense to people of what it is and why it’s so rapidly growing?
[0:01:53.6] JG: Sure. I suppose, software as a service started off as basically an idea that the founder of Salesforce had while he was working in Oracle. So software 15 years ago plus was a large expansive project that companies had to go off and build particular software for the company. IBM and Oracle would come along and they would sign an agreement with you where you had to invest huge amounts of money upfront and then you would have annual sort of servicing fees and stuff like that, but you had to invest millions and millions of dollars upfront to get a software product for your business.
Marc Benioff started Salesforce and he started around the idea of, “Well, if I can create a software product that is widely useable by a lot of people with certain tweaks for industries and different stuff like that. Well then, I should need to charge people millions of dollars upfront to use it. Why don’t I charge them $500 a month and make it really easy for them to integrate software into their business?”
That basically started software as a service, as an industry. You’re taking software but you’re paying it as a service, like you pay your telephone bill. We all don’t want to pay huge amounts of money upfront for certain things. If you can use it as a service, it makes it much easier for you to be able to finance it and integrate it into your business.
That’s the origins of it and it led to the expansion of software and software as a service into every part of our businesses and lives today.
[0:03:30.9] AH: Is it mostly business to business or is there a significant consumer element as well?
[0:03:37.0] JG: There is consumer and business to business element in software as a service. There’s lots of different types that we use today and more and more as companies grow and tech companies grow, whether the everyday household names that we know like Apple are introducing software as a service. You can think about Apple Music, that’s software as a service. They are hosting your music on their platform and letting you access it and charging you a small monthly fee for using that.
We are in the business to business software sector, so these are software products that enable companies to do lots of different things really quickly and efficiently so it might be their sales team or their marketing team or the finance team. All these different teams in the business will have different software products that enable them to be more efficient at their job and collaborate with their own customers and different vendors that they use.
[0:04:32.8] AH: I’m probably not telling you something that you don’t already know but the growth in software as a service is really incredible. I just looked it up the other day and I think in 2008 worldwide, it was something like 5.5 billion and then in 2020 it was like 155 billion, it’s just –
[0:04:51.9] JG: Growing exponentially and it’s – we don’t even know we’re using software as a service half the time in our daily lives but, you know, half the things in your phone will be run by software as a service companies. All the apps that we use, just think of Uber and the connectivity of Uber to your bank account to just every little pinpoint of actions that people take on a daily basis are touched by software as a service now. It’s led to huge improvements and safe banking, for instance, doing transactional banking on day-to-day on an app rather than have them go into a bank.
It’s made our lives a lot easier and a lot easier to do business but also personally be able to buy stuff through your online banking or e-commerce platforms or lots of different things. Yeah, it’s growing exponentially.
[0:05:44.1] AH: How did you find yourself involved in this industry?
[0:05:48.7] JG: Funny enough, my father was an entrepreneur and had a software, the old school type software business for a banking software platform. They would go into banks and they would do the big projects and charge a lot of money for the banks to put software into their business.
I always had an entrepreneurial itch. I studied at business school and then as an accounting CPA equivalent from Ireland but was always interested in how businesses set-up, ran, financed themselves and the entrepreneurial side to it. I worked in a family office that was very entrepreneurial, they invested in everything from – they started up airlines, they had hospitality business and they’ve invested in a lot of technology.
I could see that technology was somewhere that I was just very interested in. I wanted to spend the next 10 years learning myself about it but also be involved in an industry that has lots of things going on. It’s a very interesting industry that crosses lots of spectrum of different types of businesses and different types of people. It’s a very interesting industry at the end.
I knew the founders of an equity fund here in San Antonio called Scaleworks and they buy and run software companies and they started up a finance company as a side project to help their company’s finance growth projects that they had. The side project that they started at Scaleworks is venture finance. They saw they were filling a niche in the market and they asked me to come aboard and run it and start commercializing it. I moved to San Antonio two years ago and we rebranded the business and have adjusted our offering slightly to the needs of founders really and how they need to use finance.
[0:07:32.1] AH: Scaleworks, is that investing on the, more the equity side?
[0:07:36.8] JG: Yeah, they purchased majority shareholdings in SaaS, software as a service companies. These companies usually have been founder run. They usually have great products and the founders have been working in them for seven, eight, nine years and they’re looking for an exit. Scaleworks will come along, they will buy the company, provide an exit to the founder and then they’ll put in some of their own management team with the management teams that are there and all the employees. They will look to put in their operational expertise to get the company to the next level.
Yeah, that’s what Scaleworks do, they’ve been very successful, 10 or 11 companies at this stage. From time to time, they needed some finance for growth projects, sales and marketing and might have been a bolt-on acquisition. They couldn’t find the type of finance that was flexible enough for what they wanted so, they’re entrepreneurial guys, they started a separate side business doing this and they lent to a few of their own companies first and then started lending outside. Yeah, that’s when I came onboard.
[0:08:41.4] AH: What is the need that you find yourself filling, being a lender to these software as a service companies? Is it difficult for them to get financing from traditional lenders like banks?
[0:08:55.8] JG: Typically, what happens is, people will start a company, a founder will start a company. They’ll bootstrap it, they’ll use some brands and family savings, doing things on their own to get the company off the ground and they might have some small equity investors but they’re very capital efficient.
Building a software company today, you can have a product up and running within six months. You don’t need huge amounts of capital at the start to start a software company and as you grow, you’ll need different access to capital to be able to invest in your company, employ more people to expand your company.
There’s the well-known path of venture capital where you take a large size of a check and you go into the heavy cash burn situation, which sets up your company for growth but if you don’t achieve that growth, the exponential type of growth, it means that you end up with a huge cost space for your business and it’s quite unsustainable.
Then, there is a large sway of founders out there, and second time founders, we work with a lot that want to build their business in a different way. They want to access small bits of capital as they grow in different stages. It’s a much more sustainable approach to growing their business. They will invest some of their own money, friends and family or smaller equity investors to get off the ground and get the product out there and win their first customers and get their business really to be a real business.
These companies, software companies, they have no tangible assets, they have no hard assets that a bank can take hold of and sell. Its IP, its code that they have built and they’re typically – they don’t make money, they’re not profitable but they’re growing and their revenues are growing and the subscription model of these software as a service is such a cash generative basis for doing business that it’s such a steady stream of cash from a revenue standpoint that it makes it a very solid business for someone who understands the business to lend to.
I use the example of the friend who runs a chain of restaurants. He’ll open his door on Monday morning and he’s not sure who he’s going to have in the restaurant on Friday or Saturday night. Every week is different. In software, you’ll have a company that has, say 2,000 customers and those customers pay them $200 a month like clockwork.
They know that a certain amount of customers will leave every month and they know that they’re going to win a certain amount of customers every month as well. It’s a very stable solid revenue base to lend off. That’s where [inaudible 0:11:36.6] we’re lending against the strength of that revenue and the cashflow.
Typically, banks do not want to lend to those companies. Some banks have set-up departments where they will lend to them if they have a large venture capital backer behind them, which tends to give them some comfort but the companies that we lend to are set-up in such a way that they have very repeatable revenues each month. They’ve set-up the cost space in that they’re losing a little bit of money to achieve growth but they’re never far away from being able to get to profitability, which makes it a very sustainable business.
The margins that they’re able to achieve are very high margins as well. Typically, software companies should be achieved in 75, 80% plus margin, gross margins, which gives them a lot of money and ability to flex their cost base up and down if they need to achieve that growth. It’s a new space that has only come to the fore in the last few years. There’s a few that have been around for seven, eight, nine years but over the last few years, it’s really been a growing source of finance for founders.
We’ve worked with just over 30 companies now, we have repeat customers who’ve come back to us when they’ve grown and they want to take a little bit more money and if we can give them a flexible way to access capital, that’s a real win for the founders.
[0:13:01.2] AH: Is part of the attraction for the founders that they’re not giving up equity in the deal?
[0:13:05.6] JG: Absolutely. In the space we work in, there’s different offerings out there so there is debt like ours that will have an interest rate. Some lenders will put what’s called a warrant, an equity warrant on top of that, which gives them the right to take on some of the equity in the company, small, maybe one or two percent. We don’t take on warrants, we haven’t done to date. It’s just been based on an interest rate. That allows the founders to maintain full control of the business and their operations and how they settle their cost base.
[0:13:41.7] AH: What’s the typical loan? Is there a benchmark interest rate that you work off of, is it [inaudible 0:13:47] more plus certain percentage or does it vary depending on who you’re lending to?
[0:13:53.9] JG: It does depend on who you lend it to and the set-up of the company, how big they are, how diversified the customer base is, how much money they’re burning, the strength of the management team behind it, all these things play into the cost of the finance and the risk approach that we take.
Typically, our interest rates are just a base rate of mid to high teens interest rates, which sounds high but when you think that a founder might have to sell equity to get access to finance and selling their equity could cost them a huge amount of money in what those shares are worth in the future with these growing companies. This is a more flexible way for them to finance. It’s high interest rates because we have to raise money on the private markets. We don’t have a balance sheet like a bank would have behind them. This is all private money that’s raised and lending to these software founders.
[0:14:50.6] AH: What does the due diligence process look like on your end?
[0:14:54.9] JG: Most lenders will do a high amount of diligence on the company’s revenues. We are lending based on the strength of those revenues and the cash flow that’s coming up and so it’s the – you start off with their track record of monthly recurring revenues base. What does that track record look like, are they able to grow that around a consistent basis? How many customers do they have each month? Is that customer rate growing? How many customers churn each month? So how many customers did they lose each month?
Because what you want is you want a very sticky product that, you know, if people are using the product a lot, they’re not going to let it go. They’re going to continue wanting to use it, so you want a sticky product, you want growth in the customer-base on the revenue line. We diligence that back to actual cash flows that are hitting up a bank account or stripe account. From there then we assess the cost-base, the cash burn each month. Then the deal scale balance sheets, accounts receivable, accounts payable, assets and debts in the business and of course, you have a lawyer.
[0:16:03.3] AH: Yeah.
[0:16:03.5] JG: That will do all the legal diligence and draft legal contracts and stuff like that.
[0:16:08.5] AH: How often, sort of, would you be in touch with the companies that you lend to? Is it sort of like venture capital where you’re sort of constantly in touch with them to see how they’re doing or is it more of a hands-off approach?
[0:16:22.1] JG: It can be a hands-off approach depending on the company. Typically I touch base with everyone on a quarterly basis. It can be much more regularly than that, every few weeks, depending on what is going on with a company and what they need and what we can help them with. It might be for instance that they are at a stage where they haven’t had – they’ve had an accountant doing the books but they haven’t had a CFO and they’re now looking for CFO but if we can help them assess what they need, we jump in and help where we can.
Some companies may need help when they’re out raising different types of capital, they might ask us to look at decks or from a finance and investor point of view. If we can help them, that’s great. Other companies come back to you quite often and, you know, they’re growing very well and they need access to a bit more money, so you know, we’re in constant discussions with them as to what that looks like and what their revenues and what their need is in the near future.
We don’t get involved in the operational side of the business on a day-to-day. It is more hands-off than DC I would say.
[0:17:27.3] AH: I guess there’s always the thing when you’re a debt holder that you always have to – there is always the chance that you could essentially end up with the equity, right? That if for whatever reason their business goes sour, you could end up sort of owning the whole thing. Is that something that you’re comfortable with or would that be sort of a moot point in the sense that it’s probably that they’re not profitable and so you would just write that off?
[0:17:50.9] JG: If a company goes into decline and is going in the wrong direction, the best outcome for us is to work with the founders and the management teams to get an exit for us as a capital provider too and to help them turn around the business. We try and work with them, we try and help them right side the ship in terms of getting their cost base right, stop the decline in revenue and get back to trying to grow the business.
If we have to own, come in and operate a business ourselves, that’s a lot of work and we are ever only going to get our money back that we have lent to them. We are never going to make the venture capital type returns and stuff, so we want to go and we want to help them to the point where we can get our money back and there’s a stable business there that’s left that they can take on in the future and try and grow again.
[0:18:41.1] AH: You’d much rather that they can continue with the payments as scheduled rather than having to – you don’t want to become an equity investor essentially, right?
[0:18:51.8] JG: We’re not an equity investor at all, so we are capped at what we have lent plus any interest that we’re owed. Even if founders or the shareholders all disappeared tomorrow, they still own the shares. They still own the company. We can only recover what we’ve ever lent or are owed for interest from the company, so if the company gets sold for lots of money, we still only get our money back, those shareholders would gain the benefits of whatever the value that was left after that.
[0:19:20.9] AH: Who do you view as your competitors when it comes to lending to these companies?
[0:19:27.4] JG: The competitors that we have, there’s a number in our space that do both similar things to us and then provide finance in a different way to us. I think one of the first couple of lenders in our space were lighter capital and SaaS capital. Lighter Capital, they lend in a similar way to us and different size of the finance, then you have SaaS Capital who lend to the larger end of our customer base and then you get companies that do different things and ways of lending shorter term.
At the moment, there is a lot of news around short-term lending and it’s like forward factoring of revenue. There is pike.com and ClearBank who lend against the advertising spend and different things. There’s a lot of innovation going on in the space and a lot of different competitors coming in in different ways and I suppose companies need to use those different people at different stages and in different ways.
For instance, the short-term lending is great for some companies, being able to balance out their monthly cash flows and the ups and downs and the swings that they might see in those. That type of lending isn’t growth capital like you can invest in a sales team that are going to take six to nine months to start paying themselves back building their sales pipelines and different stuff like that. That is where lenders like us come in and provide capital that people can repay on terms from three to five years. It gives them a bit longer runway at using the money.
It is a growing industry. There is a lot of news in it, we haven’t seen any banks come near it yet. They just kind of get their head around [inaudible 0:21:10] companies with no assets.
[0:21:11.5] AH: Have there been more competitors on the lending side? Have you noticed a compression or a downdraft in rates or has that been offset by just how much demand there is for this kind of financing from the SaaS companies themselves?
[0:21:26.8] JG: There is a huge demand and in the alternative finance world that we operate in, it is unregulated. There’s a lot of companies out there offering debt structures, which is actually very hard to understand how much it costs, so the cost to capital is hard to – it is a little bit opaque. We try to be very upfront on, look, this isn’t like taking out a mortgage. This is more expensive debt and we give an interest rate, so it is very upfront.
There’s no hidden charges but there’s lots of companies that are charging fees and it might be a fee over six months basis, which means you know, if you try and make it equivalent to an interest rate, people have to go off and do spreadsheets and try to work it out. There is a lot of that going on in the market, so you know, I’d love to be able to – if there is one truth, source of truth for companies when they’re raising money as to their uses, their cost and the terms that would be great but there is more entrance into the market. There hasn’t been a compression in cost. If anything, the cost has become more opaque and harder for companies to understand.
[0:22:33.6] AH: When you think back to sort of your experience running the fund so far, what are some of the lessons you’ve learned, both things that you want to do again and maybe lessons of what to avoid?
[0:22:44.1] JG: One thing we’re trying to do, and a lot of people in the industry, in the FinTech industry are trying to use information of data flows from companies more and more. One thing I’ve learned in the last couple of years, and I’ve always been a big believer in, is just talking to people, talking to the founders and the management of the company. You get great insights from just having a conversation with people. You can take a lot out of data and a lot of assumptions out of data but actually hearing what went on in the company and why they made the decisions that they made and how they plan to grow the company in the future, that is a fundamental thing in business and I think that sometimes, the FinTech industry are starting to lose that a bit but those conversations and getting to know those people and how they run their companies is absolutely fundamental. When you’re investing in any company, in any industry and whether it’s equity or debt, pick up the phone and have a conversation with the people. We have multiple conversations with the management teams before we lend to them.
[0:23:40.0] AH: It is interesting, our communication style nowadays, with email it’s very easy to forgo the human component, right? I guess as you say, you learn more by picking up the phone and actually having a conversation. I think things probably come out that they wouldn’t come out necessarily over a quick email discussion.
[0:24:00.9] JG: Well, you know, a good example is the last 12 months. If we get a set of financials from a company and we see their revenues declined by 30% last March and April. We can all understand why that was, you know? Because it was a strange time in the world but trying to understand then what they did about that, not just in the numbers but how they approached their customers.
For example, a lot of SaaS companies said, “Look, our customers, instead of losing the customers, we’re going to defer your payments so we don’t lose you as a customer but we’re going to defer in the next three or four months payments. Look, we’ll see you in three or four months,” and those customers really appreciated that and they all started coming back. Little insights like that into the human side of business really helps trying to understand those numbers and how the business operates.
[0:24:48.2] AH: How much time do you spend on sort of existing loans versus evaluating new potential loans to companies?
[0:24:59.3] JG: I’d say I spend 70% of my time evaluating new companies and 30% of time on our customer base and that will vary depending on what customers need. If I can help customers, I get stuck in and we give a lot of time towards that. I am very weary that in business and in life, the more you can help someone, the more they will get out of you and if it helps their business, they are going to talk about it to other people.
The old saying, what comes around goes around, if you help someone else in a way and you know, you might not get anything out of it but they can refer someone on to you and that’s what makes the world spin. We do try and help our customers greatly but on an average month, probably 30% of my time is spent on current customers, but that varies greatly. It could be 50% one month and maybe 20 on another.
[0:25:52.0] AH: I guess with any technology, but maybe particularly software, I don’t know, I guess there is always the risk that you lend to a company and then they, the current popular phrase is they get disrupted by a new entrant. How much of that is a meaningful risk in the software as a service industry or are the companies that you tend to lend to, are they established enough that that’s not so much of a risk to their business model?
[0:26:20.7] JG: No, I think it’s a risk to everyone, all businesses of all sizes. If you are established though and you’ve been around for long enough and you’ve got a seasoned management team running the business, you can see those risks coming so you’ll know 12, 18 months in advance that someone is doing something different and they’re coming into your space a little bit more and they could be taking your customers away. It’s then on the management team and the business to respond to that.
How do they respond to that? Do they change their prices? Do they change their structure? Do they have more value that they can offer their customers? Maybe their product has a lot of data in it that they can utilize to help the companies understand their data. It is certainly a risk but it’s a risk normally that you see coming and you can respond to it. Look, every company in the world, if we look back at who were the top 10 companies in the world 20 years ago, that top 10 has completely changed and it changes every 10 years. They get pushed aside by other companies and new spaces, or disrupted, so you know, the likes of Walmart are not responding to Amazon. They’re having their own go with e-commerce online shopping. They now have to catch up to Amazon who’ve come in from nowhere 10 or 15 years ago and have really taken them on.
[0:27:38.3] AH: [Missing audio] The potential for lending to the software are those companies.
[0:27:41.8] JG: I think the financial institutions we’ve all known over the past 20 or 30 years are slowly getting dissected and broken down into companies doing very specific things. Where I see lending to SaaS companies I think that funders are going to come in and see that this is an opportunity for them to get exposure to a new industry. There is a higher return for them and as those larger funders come into the space, the cost of capital will drop for the likes of us and we’ll be able to provide cheaper finance in time to these founders as the software and revenue, recurring revenue streams become more mainstream and accepted in banking.
[0:28:28.2] AH: That’s great. Okay well, we’ll leave it there. John Gallagher of Element Finance, thanks so much for your time. This was incredibly informative and thank you to all of our PitchBoard listeners. We’ll see you here again soon. Okay, thanks very much.
[0:28:39.3] JG: Thank you Andrew.
[END OF INTERVIEW]
[0:28:40.2] JM: Thanks for joining us on this episode of The Pitch Podcast. Make sure you check us out online at thepitchboard.com. If you liked our podcast today, please make sure to subscribe to The Pitch Podcast so you don’t miss an episode.