What’s more, accounting rules don’t reflect the inherent profitability of a software company investing in growth—even when its recurring revenue is consistently strong. It’s not unusual for software firms to reinvest most of their revenue to drive growth and boost market share, with annual growth targets reaching as high as 20%–40%.
Under the Hood: Revenue Quality and Customer Value
It takes specialized knowledge and experience for lenders to assess the underlying quality of recurring revenues as well as the cost to acquire customers, and their expected lifetime values.
For example, consider a software provider with a 90% customer retention rate. When it acquires a new customer, it’s effectively gaining an asset that will generate revenue, on average, for a decade or more. But this asset can’t be capitalized under accounting rules, so the company books only a small fraction of the expected lifetime revenues each month.
The majority of costs, meanwhile, are largely tied to acquiring new customers or developing new products—key growth drivers—and must be expensed in financials when they’re incurred. This creates a mismatch between costs and long-term revenues that often leaves fast-growing software businesses reporting marginal or negative cash flow.
As we see it, many of these companies would be capable of generating positive cash flow if they were to reduce discretionary growth–oriented spending and focus on optimizing profitability.
Recurring Revenue: It’s Not All Created Equal
The quality of the revenue matters too. Lenders must be able to determine whether firms are generating enough revenue per customer over time to cover the overall costs of running the business and create value for investors. That’s why it’s essential to understand the profitability of each service line they provide.
Doing this well requires detailed analysis of factors like the cost of acquiring a new customer, the variable gross profit of an existing customer and customer retention rates.
The insights are critical. They may clarify how much flexibility a software company possesses to reduce some of its discretionary spending. That flexibility will be important if high interest rates and slower growth start to suppress the returns that a firm realizes on investments sales and marketing spend.
Sizing Up the Lending Opportunity
In our view, the loan amount depends on several factors including the quality of the underlying revenue, the projected lifetime value of a company’s customers versus the cost to acquire them, and the marginal profitability of each dollar of revenue.
We believe it’s crucial to assess the underlying profitability of the business based on its contracted recurring revenues. In effect, a lender can determine the appropriate loan size based on the ratio of debt to earnings before interest, taxes, debt and amortization (EBITDA) of the business if it was run for profitability. Then the lender might use this to size and quote the loan on a debt-to-ARR multiple.
Think of a company that charges a fixed software-subscription fee—let’s call it $5,000 per month. That’s visible, regular income. And the software plays a critical role in the customer’s operations, which usually leads to high contract renewals. That’s good news for lenders who get a clear view of how much the borrower will earn each month.
Similarly, consider a software company with strong customer retention, a high variable gross margin and an efficient sales and marketing operation. This borrower may warrant a loan that’s a higher multiple of its ARR because the strong economics of each unit sold helps keep debt at a manageable multiple of its EBITDA. On the other hand, even a low debt-to-ARR loan to a software company with poor unit economics may be risky if the debt-to-EBITDA multiple is high.
Loan Covenants: Guardrails for a Pathway to Profitability
The ultimate goal—for both lender and borrower—is a business that eventually turns a profit. As we see it, loans should not be structured on a recurring-revenue basis if lenders don’t think the business can generate an appropriate profit.
Direct lenders can safeguard their investment by including protective loan covenants tied to recurring revenues, the company’s liquidity and a requirement to become profitable by a certain time frame.
For example, a five-year loan might be made on a recurring-revenue basis but with a covenant that requires the borrower to meet or beat a predetermined earnings threshold after two years.
With this “covenant flip,” the lender puts the borrower on the clock: by a certain date, the company must show that it’s generating a certain level of profit.
Covenants requiring a company to maintain enough liquidity to support growth and to meet payroll and other core needs also help lenders monitor loans. Even healthy companies can run into trouble if they fund unprofitable growth with debt.
In the big picture, we see recurring-revenue loans as an attractive way to finance growth-focused software firms and round out private credit portfolios. But two similar companies may be quite different under the hood—differences that matter in structuring loans effectively.
