In the first of a series of pieces on venture debt and its applications in this market, Lyall Davenport, Principal at Claret Capital Partners, explores the use of debt to make acquisitions.
Venture debt is emerging as a savvy financial tool, particularly for M&A in today’s market where equity now comes at a premium cost and company valuations are more conservative. The tougher macro environment also makes organic growth more challenging as customer budgets are under pressure. Many players that would previously have raised equity and sought to pursue a land grab strategy are now considering consolidation within their segment as a better route for their shareholders.
Venture debt offers a way for businesses to minimise external pricing rounds and consumption of expensive equity. This kind of consolidation is a strategic move, whether you’re looking to enhance your product suite or boost your annual recurring revenue (ARR) and companies that can tap into this type of growth capital have a golden opportunity. Historically we at Claret have supported consolidation by companies like Job and Talent, Playtomic, and Helpling with debt facilities. These facilities have been game-changers for two main reasons; they minimised dilution and served as a catalyst for growth.
Applying consolidation through debt to SaaS:
The current valuation landscape for SaaS companies is the most subdued we’ve seen since 2017, both in the volume of capital invested and the multiple payed for rounds (see below) making this a good place to start looking at consolidation. With a quieter IPO market, even high-performing companies find it challenging to raise capital without compromising on valuation.
For those that have the management capacity to integrate high-quality M&A targets effectively, it’s an opportune time to be in acquisition mode. This is particularly true when there are significant operational synergies both in the operating cost base of the business but also in the cross-sell opportunities, while customer budgets are tight and equity is expensive it is often more efficient to buy than build a clear path to sustainable, high-margin growth.
While there’s been buzz around M&A as a business model, the current focus is on a more traditional approach to M&A – think strategic bolt-ons or trade sales rather than the high-profile roll-ups of recent years.
Worked Example:
To illustrate, let’s consider two fictional SaaS companies, neither of which has existing debt: “Alpha,” with a €30M ARR, and “Omega,” with a €10M ARR. Post-acquisition they’ll merge into “A2”, boasting a combined ARR of €40M. For simplicity, we’ll apply a uniform multiple of 4.8x for valuation, in line with median M&A values for Q2-23 from the recent GP Bullhound Insight into Software Valuation report.
Here’s the breakdown: A2’s enterprise value (EV) assumes €20M in debt, reflecting a day-one valuation at the 4.8x multiple. Alpha will need to secure debt financing for the acquisition, with the remainder covered by equity in A2. We’re assuming a debt load of 50% of the proforma ARR, equating to €20M in debt and €28M in equity issued or paper taken by the vendors. The debt terms include a 12-month interest-only period, followed by 36 months of amortization, and the equity warrants issued will represent 1.25% of A2 (12% Warrant Coverage at the proforma valuation).
Disclaimer: These figures are purely for illustration. Actual ratios and terms will vary based on each lender’s criteria, risk tolerance and the borrower’s profile.
So, what does this mean in practice?
Based on our assumptions and some straightforward calculations, it’s clear that significant value is preserved for early shareholders and the founding team. The dilution from equity issued (plus the warrants granted to the debt provider) is 20.69%, which is markedly less than the 33.33% it would have been with a full equity raise at current valuations—a 42% delta.
Looking ahead, if A2 achieves a 50% year-over-year growth and maintains the 4.8x multiple, the EV increases significantly, leaving €22M to €123M in value for shareholders in A2 over four years. And if market conditions improve, pushing multiples closer to the 6.0x or even 10x seen in previous years, the financial upside for A2’s shareholders could be even more substantial.
In essence, while there are numerous variables at play (and we’re assuming A2 hits all its targets without any additional dilution – a hopeful scenario!), the core argument holds. Using venture debt for acquisitions can prevent considerable dilution and retain more value for all shareholders, particularly those who might not have the leverage to protect their stakes, such as founders, management, and early investors.
I hope this has been a useful illustration to start the conversation here – I am excited to keep this series going (if I say it here I am more likely to keep putting them out) – please feel free to reach out to me on Linkedin or directly at ld@claret-capital.com to continue the conversation!
Useful links:
GP Bullhound Q2 2023 insights into Software: https://www.gpbullhound.com/articles/q2-2023-insights-into-software/
Calculations for above: https://docs.google.com/spreadsheets/d/1SXTbVPgQwRt2Wuhl8ETVaGW983uvyZet/edit?usp=sharing&ouid=108260805507226966038&rtpof=true&sd=true