Sources of Funding for SaaS Startups Explained
Last updated on
December 2, 2022
The road to SaaS stardom can be long and hard. As a startup founder, you’re developing a complex product that has the potential to change the world and make someone’s everyday life easier. It makes sense that such a great task comes at no small cost.
Luckily, the financial ecosystem we live in recognizes the world-altering power of technology and software. Today, many systems are in place to help startups centered around brilliant ideas grow and thrive.
This article explores these systems—the financing options available to founders to help them develop from the idea stage to fully operational company, with even a unicorn status.
Read on to expand your knowledge on terms like bootstrapping, startup incubators, and accelerators. Learn what to expect from angel investors, venture capital, love money, crowdfunding, and bank loans.
By the end of this article, you should be able to understand how each one connects to your project and when to seek it out.
Table of Contents
Getting Started Without External Funding and Support
A great feature of starting your SaaS business from scratch is that you can make a lot of progress largely unfunded. That’s because the overhead costs of creating a SaaS product are relatively low when compared to production costs in other industries.
Capable developers can get very far on hard work and knowledge alone, which is why many SaaS companies start out as side-businesses of their founders.
A great example of a famous company that started as a side hustle is Apple, whose founder, Steve Jobs, worked at Atari while he and his co-founder, Steve Wozniak, an engineer at HP at the time, worked on building a user-friendly personal computer in Jobs’s garage.
To finance this endeavor, Jobs sold the only thing he had of value, his VW van. Wozniak sold his HP-65 calculator for $500.
With that money, they managed to create a prototype which they offered to Atari, but were turned down. Instead, Al Alcorn, the original creator of Pong who worked for Atari in those days, introduced the pair to venture capitalist investors—and the rest, as they say, is history.
In the world of tech, the story of Apple is no exception.
Many companies rely solely on the founders’ own funds. This is called bootstrapping, and it’s a common way to start your SaaS business without any external resources and funds, other than a brilliant idea and hard work.
You can think of bootstrapping as the early stage of your company before you find other funding sources, but in some cases, SaaS companies have bootstrapped their way to success without any external assistance.
Take Kinsta, the WordPress hosting company, for example.
They started out in 2013 and invested everything they had into their product, accepting that their company would grow more slowly than it could with investors.
Today, they bring in six figures in ARR and boast 20,000 clients.
One of their founders, Tom Zsomborgi, says that bootstrapping was harder than they expected, but the whole team remained dedicated to building a team, solving problems and driving innovation, self-learning, and responsible self-management instead of focusing on the money coming in from their clients.
So, how do you recognize that pivotal moment when it’s time to look for external funding? Well, truth be told, there’s no single answer to that question.
The rule of thumb is to strive to grow your business as much as you can without external help.
Once you get to a point when further growth is impeded by a lack of funds, that’s when you should turn to external sources to finance the development of your product.
Going after external funding too late could bring your business to a grinding halt because you won’t be able to afford the resources needed to continue scaling.
These resources could be new staff, legal advice, marketing and PR, or anything else you can’t—as a tech expert—provide yourself.
On the other hand, too much funding too early can be just as detrimental.
At the early stage of your company, when you’re still not sure what direction your product will take in the future, you could become overwhelmed by the investors’ expectations and rush into developing a product without the right market fit.
Once you recognize the right moment to turn outward and look for funding and support, you’ll find a world of opportunity.
From incubators and accelerators to angel investors and venture capital, there are many resources that will help you develop your product until you’re ready to share it with the market.
The following sections of this article will look at those resources in more detail and explain how each one can help you on your way.
Startup Incubators and Accelerators
Startup incubators and accelerators are a great place to start for early-stage tech startups. They provide resources to new companies to develop their ideas, get traction and raise funds to keep growing.
The problem, however, is that top-tier startup incubators and accelerators are notoriously difficult to get into.
Their acceptance rates are somewhere around 1%, which makes them even more selective than most Ivy League schools.
Have a look at the application funnel below to see just how selective the procedure can be. Out of 3,000 applicants, only a fraction will be accepted.
Another thing to keep in mind is that, even though the terms incubator and accelerator are sometimes used interchangeably, significant differences exist between the two.
They offer similar resources to support growing companies, but incubators typically accept very early-stage companies who are at the beginning of their journey with little more to show than their great ideas.
Another major difference is that accelerators often offer funding on top of non-monetary resources like mentoring and business support, while incubators are most commonly based on support other than finances.
Nevertheless, incubators sometimes also offer small investments of up to $100,000.
Let’s look at an example of a famous incubator and accelerator to see how they operate.
Techstars is one of the most prestigious incubators in the world.
They accept 40 startups into their program every year and offer each one a $100,000 convertible note, as well as $20,000 in exchange for 6% equity.
Other than access to capital, Techstars provides mentorship and training, which many member founders come to appreciate even more than the monetary injection.
It also sets up new entrepreneurs with office spaces and gives them access to a wide network of experts and professionals, as well as opportunities to pitch their projects at events, such as Demo Day, to raise more funds.
Their portfolio spans over 1,500 companies, including nine unicorns.
On the other hand, a famous example of a startup accelerator is Y Combinator. It differs from incubators, like Techstars, in that it usually allows founders to work on their products with very little interruption.
Y Combinator also offers mentoring but partaking in their training and mentorship programs is optional.
Y Combinator prefers to organize less structured events, such as their famous Dinners, where they invite influential people from the tech and business world to talk about their experiences and inspire new founders.
In terms of startup capital, Y combinator offers $125,000 in exchange for 7% of the company.
They also take care of living expenses so that participating companies can dedicate all of their time to building their product.
As the company progresses, they keep making minor investments, but they keep their equity at around 7%. And, of course, they organize pitching events where successful founders raise as much as $1-5 million.
Y Combinator’s portfolio boasts some of the most famous companies out there, like Airbnb and Reddit.
Just look at that list of alumni. Quite impressive, isn’t it? These are just two top-notch examples of incubators and accelerators, but there are so many more to look into.
So, if you have an idea for a SaaS product that could improve a lot of people’s lives, definitely consider applying. Startup incubators and accelerators are a great starting point to fast-tracking your company on its way to success.
Once you’ve had some time to flesh out your idea and have something more tangible to show investors, it may be a good idea to look into getting angel investors involved.
Angel investors are wealthy individuals who support growing tech companies by making small-scale investments in exchange for a low percentage in company equity.
The appropriate time to seek out angel investors is in the early stages of your company’s development, usually between the first and third year.
That’s because these individuals make relatively low contributions (the median angel investment is around $25,000, research has shown) when compared to later-stage investors, such as venture capitalists.
Another reason why it’s a good idea to find angel investors early on is that they tend to be entrepreneurs and tech experts themselves, with a lot of experience under their belt.
That means they can use their knowledge to help you build a strong foundation for your firm and move in the right direction with your product.
Angel investors can put you on the right track and provide funds when you’re in dire need of them in order to keep working on your project. They make a profit when their shares grow in value after acquisition or a merger, or once the company goes public.
If this sounds like the right move for your young company, you can start getting a proposal ready and seeking out potential investors. They usually keep a low profile, but there are platforms in place that can help you get in touch with them, such as the Angel Capital Association.
What do angel investors look for in a company?
Let’s turn to one of the most successful investors operating in the US to find out.
Jonathan Hung is a Los Angeles-based angel investor and venture capital partner who specializes in early-stage investing and the formation of strategic business partnerships.
He’s one of the most active angel investors in Southern California.
According to him, the number one factor angel investors look for in a company is earning potential.
Having a great idea that can make an impact is great, but if it doesn’t have the potential to make lots of money, you’re going to have a very hard time finding angel investors.
In other words, angel investors are attracted to ideas that can bring them a solid return on their investment. Their expectations can vary a lot, but some sources note that angel investors tend to aim for an ROI of 30-40%.
A large survey of 300 investors supports Hung’s claim and adds “solving some of the world’s biggest challenges” as another great motivator shared by angel investors.
Apart from money potential, Hung also lists providing an exit strategy for investors, having a robust team, and a high level of personal commitment to the company from the founder as crucial for attracting angel investors.
Remember that there are many angel investors out there that are just looking for their next investment opportunity. All you have to do is find them and show them why you’re so convinced your product will succeed.
The leap from angel investors to venture capital is a significant one. Venture capitalists usually get involved when your product is being introduced into the market.
Some VC investors like to get involved earlier than that, in early development, which carries a significant risk of failure, but also increases the potential for a massive payout at the end.
However, in most cases, when a venture capital investor steps in, your idea isn’t so much of a concept being researched and developed, but more of a product meant for consumption.
As you may have already guessed, this means that investments from venture capitalists are far larger than those of angel investors. While angels invest in tens of thousands, the amount of money invested by venture capitalists is measured in millions of dollars.
As with angel investors, venture capitalists will also expect equity in return. How much equity?
Well, that depends on the size of their investment, the point at which they get involved, and how many investment rounds there are.
Let’s see some examples.
As you can see above, by the time of exit, venture capital investors may own more than half of your company.
Another key difference is that venture capitalists are large institutions, such as financial companies, retirement funds, and universities, not individuals.
One of the biggest players in the venture capital game is Sequoia Capital. They invest mainly in the technology industry, and the companies they support control a combined stock market value of $3.3 trillion.
Sequoia’s portfolio includes giants like Apple, Google, Oracle, Youtube, Instagram, Zoom, WhatsApp, Linkedin, and Paypal.
If you’re wondering how you can put your company on the fast track with VC, the process is, unfortunately, not an easy one.
First of all, even getting your foot in the door is a great challenge because venture capitalists don’t usually take meetings with unknown founders.
Secondly, as we’ve already mentioned, your product would have to be pretty far along to grab the attention of investors. In most cases, you’d need to have a functional MVP and early adopters for your product.
Finally, if you manage to jump through all of those hoops, you’ll need to craft a perfect pitch and present some business plan to succeed in securing VC funding.
According to Don Valentine, the founder of Sequoia Capital, investors like to see a perfect product-market fit.
Michael Moritz (Sequoia partner who signed on Dropbox) adds that venture capital investors usually back founders who can translate a complicated piece of software into a powerful story they can understand and get behind.
Getting venture capital on your side is no easy task, but it’s definitely possible. Therefore, don’t be too intimidated to seek it out once your product matures enough.
Other Sources of Funding
The few types of funding we’ve mentioned in this article by no means make up a complete and definitive list.
Funding for your product can come from many other sources, and it’s important to explore as many avenues as possible to create a robust and stable company that stands on more than one leg.
An unskippable part of funding for almost any founder is the money they secure from friends and family. Even though investments from loved ones are relatively small, they’re incredibly helpful when you’re starting out for a couple of reasons.
Firstly, the so-called love money is easy to secure.
Your loved ones invest in your venture because they believe in you, personally. That means you don’t have to provide much more than an idea and your personal guarantee that the money will be repaid.
Secondly, this kind of investment is what we call “patient capital”—a type of investment you won’t have to pay back for a long time, precisely because it’s based on trust.
As the graph above shows, aside from philanthropy, love money is the most long-term investment you’re ever going to acquire.
The graph also depicts the final reason why investments from loved ones are so useful. Family and friends won’t expect a large return on their investment, other than the funds they trusted you with.
Another very interesting means of financing for you to explore is crowdfunding.
It’s easy because you don’t need to work on convincing equity investors, but rather appeal to your target audience with a product that will make their lives better and easier.
And it’s safer because you’re not expected to give the money back should the project go south.
That last point should not be taken lightly, though.
The company was later purchased by Facebook for no less than $2 billion!
The convenience and safety of crowdfunding make it very appealing to founders, but a word of caution is in order.
Crowdfunding in isolation probably isn’t the best way to finance your entire project, so try to pool resources from multiple channels (like the other ones listed in this article) to ensure you can deliver on your promise.
Will Schroter, the founder of Startups.co, has 25 years of experience in launching startups and helps founders with every aspect of launching.
He recommends acquiring the first 30% of your capital from other sources before turning to your target audience with a crowdfunding campaign.
The final source of financing we will be touching upon in this article is bank loans.
These fall on the riskier side of financing options. Unlike with crowdfunding, you will have to produce a personal guarantee before you’re approved for a loan.
This usually comes in the form of the deed to your house, or any other personal assets you may have, which means that if your enterprise fails, you risk losing much more than your company.
Nevertheless, many startups opt for bank loans as a source of funding regardless of the risks involved.
That’s because, once again, not much is needed to secure a personal loan other than a good credit score and a solid business plan. That makes this source of funding appropriate for the earliest stage of your startup.
However, if this is an option you’d like to explore, make sure you do your homework as banks have very different conditions attached to loan approvals.
In addition, do what you can to improve your credit score and, as always, craft a killer business plan to present to the bank.
Remember, the term “investor” is very flexible. Your loved ones can invest in your business, and so can a group of interested strangers.
Finally, there’s never going to be anyone who believes in you more than yourself, so don’t be afraid to invest in your own project, even if that means taking out a personal loan.
One of the ideas that this article has attempted to relay to you is that there are sources of funding for each and every development stage of your SaaS business.
Do you have a brilliant software idea you’re passionate about and nothing else? Great, you can begin working on it as a side project and see if you’re eligible for a local startup incubator.
Have you completed your business plan and developed a killer prototype? It might be time to go after some angel investors and maybe take out a small bank loan.
Is your product in the MVP phase with a small army of excited early adopters? Well then, knock on the doors of venture capital and see who answers.
If you’re still wondering whether or not you should try your luck in the incredible world of SaaS business because of money concerns, don’t let that stop you. As long as you have a great idea and are willing to put in the work, there are resources that will help you on your way to success.