Can a software business borrow against recurring revenue?

Software businesses are the opposite of the usual lending problem. There is almost no collateral — a few laptops and a lease — and the cash flow is unusually predictable. Lenders who work in the sector have built products around exactly that shape, and they underwrite retention, not assets.

That percentage is the test worth running. If your gross margin is 78 per cent and your sales and marketing spend is 40 per cent of revenue, a 13.3 per cent debt service line has to come out of something. Facilities in this sector are usually taken to fund customer acquisition, which is sensible only if the payback period on that acquisition is comfortably shorter than the amortisation.

The deferred revenue trap

Annual prepayment is standard and commercially desirable — it pulls a year of cash forward and improves retention. On the balance sheet it is a liability until the service is delivered.

Suppose current assets of 1,100,000 and current liabilities excluding deferred revenue of 380,000. Current ratio: 2.89. Healthy.

Add 1,450,000 of deferred revenue from annual contracts. Current liabilities become 1,830,000 and the current ratio is 0.60.

Nothing about the business changed. If the facility contains a current ratio covenant with a 1.25 floor and the definition of current liabilities does not exclude deferred revenue, you are in breach on the day you sign, and you will be in deeper breach every time you close a good annual deal.

This is the single most common covenant problem in software lending and it is entirely avoidable. Get deferred revenue carved out of the current liabilities definition, in the credit agreement, before closing. A lender who understands the sector will agree without much argument; one who will not is telling you they do not understand the sector.

What the covenants actually test

What is actually pledged

A blanket lien on everything: accounts, contracts, general intangibles and intellectual property. The intellectual property is the real collateral and it is close to worthless on a forced sale without the team, which both sides know. What the lien does is give the lender control in a restructuring rather than recovery value in a liquidation.

Two specifics to read closely. First, any restriction on granting licences, which can be drafted broadly enough to interfere with ordinary commercial deals. Second, whether a change of control is an event of default and whether it requires consent — this determines whether your lender has a seat at the table in an acquisition.

The alternatives and how they compare

• A revenue-based facility repaid as a percentage of monthly receipts, which flexes with the business and typically costs more than term debt. The mechanics are in how revenue-based financing repayment works.
• A term loan with a fixed amortisation, which is cheaper and less forgiving.
• A line of credit against receivables for businesses selling to enterprises on net 60 terms, where the receivable is conventional and the annual contract is invoiced up front.
• Selling the annual contracts outright to a purchaser of recurring revenue streams, which is not debt and does not sit on the balance sheet the same way, but transfers the customer payment relationship. Read what happens if the customer cancels.
• Equity, which costs more in the long run and does not have covenants. The comparison is set out in is revenue-based financing cheaper than equity.

What to have ready

A cohort retention table by month of acquisition. Monthly recurring revenue with new, expansion, contraction and churn broken out separately — a single net number is not enough. A deferred revenue schedule and a reconciliation between billings, revenue and cash receipts. Customer concentration by contracted value. Gross margin including hosting and support costs, which is where a business with a thin real margin gets found out. Contract terms: length, auto-renewal, notice and payment terms. And your cash runway calculation with the assumptions visible.

What to ask for and what to refuse

Ask for deferred revenue to be excluded from current liabilities in every covenant definition. Ask which retention measure the covenant uses and model twelve months of plausible outcomes against it. Ask what the cure is for a covenant breach — an equity cure right, where an investor can inject cash to fix a ratio, is common and worth having.

Ask what the facility costs if you repay it in month 14 of 36. A prepayment penalty or a minimum-return provision can make an early exit far more expensive than the headline rate implies, and software businesses refinance frequently.

Refuse a covenant package that tests a monthly ratio on a business with lumpy enterprise billings, when a quarterly test measures the same thing without manufacturing technical defaults. And refuse to sign a facility whose recurring revenue definition includes one-off implementation fees or professional services — that is not recurring, and a definition that pretends otherwise will size the facility on revenue you cannot repeat.