Revenue-based financing presents a compelling alternative for businesses seeking growth capital without the downsides of traditional loans or equity financing.
Its flexible repayment structure, non-dilutive nature, and alignment with business performance make it an attractive option for many enterprises.
As the global market continues to evolve, RBF is set to play a significant role in the future of business financing, which is what we’ll discuss in this article
What is Revenue-based Financing?
Revenue-based financing (RBF) refers to a means of raising funds, where investors provide capital, in return for a stipulated percentage of a company’s ongoing total revenue.
The amount to be repaid fluctuates with the borrower’s financial performance — going up when revenue increases and going down when it decreases.
Revenue-based financing can be seen as an alternative form of finance — that operates on a different model to traditional equity-based investments, like angel investing and venture capital.
Revenue-based financing is also known as revenue-based funding, royalty-based financing, royalty financing and a revenue loan.
Read Also: Loan for Startup Business in Nigeria This Year
How Does Revenue-based Financing Work
Although an enterprise that raises capital through revenue-based financing will be required to make regular payments to pay down an investor’s principal, it is distinct from debt financing for a number of reasons. Interest is not paid on an outstanding balance, and there are no fixed payments.
Payments to an investor have a directly proportional relationship to how well the firm is doing. This is because payments vary based on the level of the business’s income.
If sales fall off in one month, an investor will see his or her royalty payment reduced. Likewise, if the sales in the following month increase, payments to the investor for that month will also increase.
Revenue-based financing also differs from equity financing as the investor does not have direct ownership in the business. This is why revenue-based financing is often considered as a hybrid between debt financing and equity financing.
In some ways, revenue-based financing is similar to accounts receivables-based financing, a type of asset-financing arrangement in which a company uses its receivables—outstanding invoices or money owed by customers—to receive financing.
The company receives an amount that is equal to a reduced value of the receivables pledged. The receivables’ age largely impacts the amount of financing the company receives.
Revenue-based financing is an alternative or complement to equity or debt financing. As a good fit for growing startups, it allows startup founders to maintain more ownership and control of their business than they would under equity financing.
Read Also: What is Debt Financing in Business? A Comprehensive Guide
Revenue-based Financing vs. Debt and Equity-based Financing
Revenue-based financing seems similar to debt financing because investors are entitled to regular repayments of their initially invested capital.
However, revenue-based funding does not involve interest payments. Instead, the repayments are calculated using a particular multiple that results in returns that are higher than the initial investment.
Also, in revenue-based financing, a company is not required to provide collateral to investors. Unlike equity-based investment models, there is no transfer of an ownership stake in a company to investors.
However, it is common that some equity warrants may be issued to investors. Finally, in such an investment model, a company is not required to provide investors with seats on the board of directors.
Pros of Revenue-based Financing
1. Cheaper than equity
With expectations for 10X-20X returns, Angel and VC funding are the most expensive sources of capital possible if your startup is successful.
2. Retain more ownership & control
When it comes to revenue-based financing (RBF), investors generally do not take equity. As a result, there is no ownership dilution to founders and early equity investors. In addition, RBF investors do not take board seats or place difficult financial covenants on a company. Founders are able to maintain control and direct the company towards their vision.
3. No personal guarantees
Bank loans require personal guarantees from founders based on the high-risk nature of startups. This requires founders to put their personal assets, such as a house or car, on the line. Founders can breathe easier under RBF knowing that no personal guarantees are required.
4. No large payments
Monthly payments are based on a percentage of your monthly revenue. This means if you experience a bad month, your monthly payment will reflect that and you are not burdened with a large payment you can’t afford.
5. Shared alignment towards growth
As part of their “growth-at-all-cost” approach, VCs overstuff companies with capital until they self-destruct. Since RBF involves a flexible repayment structure, investors’ returns increase when the startup grows faster. As a result, both the entrepreneur and investor share a common goal for the company to grow revenue.
6. Faster funding timeline
Pitching to venture capitalists can take anywhere from months to years before securing a deal. Since RBF investors do not require companies to achieve hyper-growth or large equity exits, lenders can provide funding in as little as four weeks.
7. Financing optionality
Revenue-based financing allows founders to grow and become more established, making traditional forms of financing more attainable. Options for financing include:
- Delaying venture capital – RBF helps extend cash runway, which not only helps delay venture capital, but can help set higher valuations as a company reaches development milestones.
- Running the business long term – Because VC’s take on equity, they are looking for the company to “exit” or form a sale of the business. Since RBF investors do not require an exit since the investment is repaid over time, founders are able to keep their companies for as long as they’d like.
- Option to sell the company – On the other hand, founders may decide they want to sell the company. Under VC financing, VC investors have the power to veto a decision to sell the company. RBF allows the sale of the business if the entrepreneur wishes to do so, as long as the loan is repaid.
Read Also: Alternative Financing in Africa: Unlocking Capital for Growth and Innovation
Cons of Revenue-based Financing
1. Revenue required
Because this form of financing is revenue-based, pre-revenue startups are generally not a fit. A revenue-based investor uses metrics such as MRR/ARR and growth projections to determine eligibility for a loan.
2. Smaller check sizes than VCs
Venture Capital is known for shoveling out enormous amounts of cash for companies, even if they are pre-revenue. Investors in RBF deals will not provide capital that is worth more than 3 to 4 months of a company’s MRR. However, RBF investors may choose to provide follow-on rounds as a company grows, providing entrepreneurs access to more capital over time.
3. Required monthly payments
RBF requires monthly payments unlike equity financing. Startups may find themselves tight on cash, so it is crucial to take on a healthy amount of revenue-based financing that aligns with the company’s financial status and plans.
Conclusion
Revenue-based financing provides an opportunity to earn lucrative returns. Nevertheless, an investor should be aware of the risks associated with the financing model because the repayment rate has a direct relationship with revenues.
If the company’s revenues experience a significant decline, the repayment rate will drop proportionally. In addition, the revenue-based financing model is not suitable for every company. The model works only with companies that are generating sufficient revenues.
In addition, a company that aims to resort to revenue-based financing must have strong gross margins to ensure their ability to repay the investment. Generally, revenue-based financing works best with SaaS companies.
References
