It is not always simple to obtain funding to cover initial or growth-related business expenses. Sometimes financial institutions are hesitant to lend money or want guarantors for loans. When looking for funding, venture capitalists (VCs) and angel investors (if you can find them) prioritize high returns and a sizable stake in the company.
This is problematic for the business owner. How can you secure financing for your company without having to forego essential equity or incur excessive debt?
Revenue-based financing may be the missing link between the safety of traditional bank loans and the high risk of private equity investments for firms. We’ll talk about revenue-based financing and how to figure out if it makes sense for your company.
What is revenue-based financing?
Companies can secure funding through revenue-based financing (sometimes called royalty-based financing) agreements by promising to pay back the investor a predetermined share of future earnings.
An investor makes a loan commitment to a company in exchange for a percentage of the company’s monthly revenue, with repayments calculated in the same fashion. This means that there are no set monthly payments and that the amount repaid will vary based on factors such as the company’s success and the timing of repayment.
Payments are usually made until the agreed-upon total is paid off. This number is typically estimated as a multiple of the initial outlay, typically between 1.5 and 3 times the initial outlay.
Loans to businesses depending on their revenue are common because repayment is directly related to financial performance.
- Fixed repayment target: Revenue-based financing is a loan with a fixed payback target that must be met over a period of time.
- Fixed payback amount: Revenue-based funding typically has a repayment amount that is 1.5 to 3 times the principal loan.
- Repayment durations are adjustable with revenue-based funding; pay back the agreed-upon amount sooner if possible or later if necessary.
- There is no loss of equity: Revenue-based finance does not require business owners to sell shares or give up control.
- More hands-off than private equity: Revenue-based finance firms work more closely with you than bank lenders but are less hands-on than private equity investors.
How Revenue-Based Financing Works
Revenue-based financing is similar to debt financing in that the business must make regular payments to the investor to reduce the principal, but it differs from debt financing in several other ways. There are no regular payments required, and no interest is charged on any balances.
The amount an investor receives is related to the company’s success. This is because the size of the payouts depends on the company’s financial success. Royalty payments to investors may be cut if monthly sales are below expectations. Similarly, if the following month’s sales are higher, the investor’s payout will be higher.
The investor in revenue-based financing does not have any equity stake in the company. For this reason, revenue-based financing is typically viewed as a cross between debt and equity.
Accounts receivable finance is one form of asset financing in which a business borrows money against the value of its unpaid bills or other receivables from its customers. Revenue-based financing is comparable to this type of financing in certain respects. A sum equivalent to the discounted value of the receivables pledged is paid to the company. The amount of capital a business receives is heavily influenced by the average age of its receivables.
Revenue-Based Financing and Revenue Bonds
Although they are distinct kinds of financing with distinct technical specifics, revenue-based financing is analogous to the cash flow arrangements seen in revenue bonds. Many municipal projects will issue revenue bonds instead of general obligation (GO) bonds to finance specific projects such as infrastructure. A toll road is a good example. These ventures pay down debt by generating secured income from the project or asset. As a result, the term “revenue bond” was coined.
Who should get revenue-based financing?
High-growth firms, specific startups, established organizations with cash flow issues but still maintaining high revenue, and borrowers who cannot qualify for standard financing due to weak personal credit are typical candidates for revenue-based financing. To be eligible for revenue-based financing, it is not necessary to have solid personal financials, collateral, or an established business.
Since revenue-based loans are dependent on current income, they are not available to businesses in the pre-revenue phase. Some new businesses can benefit from a business line of credit or another type of startup financing before they start making money.
Revenue-based funding is appealing to the following groups:
- Companies in the early stages of development looking to hire more salespeople.
- Companies that are in the process of introducing a new product.
- Companies on the verge of launching a large-scale marketing campaign.
- A corporation having a well-established market but not one large enough to attract venture capitalists.
- Owners who do not wish to guarantee a loan or sell equity.
Revenue-based financing is not the optimal option for every business. Before pursuing it, you should consider the following:
- Your company should have a dependable revenue stream from which to collect debt service payments.
- Your company’s market should be relatively stable and established. Your finances should be in good standing.
- Ensure you have an accurate summary of your debt, revenue, operating expenses, and projections for the future.
Revenue-based financing vs. bank loans
Many firms seek funding from banks. However, revenue-based financing is sometimes a superior option. Let’s compare invoice factoring to a bank loan as one sort of revenue-based finance.
Bills are used as collateral in invoice factoring. You sell outstanding bills to an investor for less than what is owed, say 80% of the total. Your company receives immediate payments, and your clients pay the buyer rather than you for the goods provided.
Invoice factoring provides the following benefits:
There is no debt or interest accrued. The typical interest rate on a bank loan ranges from 2.5% to 7%, depending on the lender, loan type, collateral, and other factors. There is no debt or compounded interest in invoice factoring. It also requires no payments because you are selling the bills to lenders upfront.
The approval process is quick. With invoice factoring, approval is obtained more rapidly. A bank loan can take weeks or months, but if you have good credit clients, the invoice factoring process can be completed in a matter of days.
Your credit score is not taken into account. Your business or personal credit is irrelevant with invoice factoring because your customers pay the investor.
There are no capital restrictions. Bank loans limit the amount of cash you can borrow, but invoice factoring allows you to continue converting invoices into cash as long as you have creditworthy customers.
Bank loans require borrowers to pay a portion of the principal plus interest on a regular basis until the entire amount is paid. Bank loans offer several significant advantages:
You don’t require dependable consumers. Invoice factoring is dependent on the availability of invoices from a suitable customer base. A bank loan may be a better alternative if you require more money than your invoices can give.
Banks offer numerous loan choices. If you have strong credit, you may frequently negotiate lower interest rates and more flexible payment plans.
Bank loans safeguard client information. A bank loan does not compel you to give another entity your customer information, like invoice factoring does.
Revenue-based financing is a viable alternative to debt and private equity funding
- Debt financing: While debt financing allows owners to retain total control of their enterprises, they must occasionally put up personal assets as security – and even then, only for a small amount.
- Private equity funding: When it comes to private equity financing, founders frequently object to losing complete control of their company. In exchange, they have access to their finance partner’s resources, network, and experience.
The revenue-based financing option is a hybrid between the two of these possibilities. Despite the fact that investors are not likely to sit on the board or interfere in operations, they do keep a stake in the success and growth of the firm in a manner that banks do not.
Many firms seek funding from banks. However, revenue-based financing is sometimes a superior option. Let’s compare invoice factoring to a bank loan as one sort of revenue-based finance.
Bills are used as collateral in invoice factoring. You sell outstanding bills to an investor for less than what is owed, say 80% of the total. Your company receives immediate payments, and your clients pay the buyer rather than you for the goods provided.
Invoice factoring provides the following benefits:
- There is no debt or interest accrued. The typical interest rate on a bank loan ranges from 2.5% to 7%, depending on the lender, loan type, collateral, and other factors. There is no debt or compounded interest in invoice factoring. It also requires no payments because you are selling the bills to lenders upfront.
- The approval process is quick. With invoice factoring, approval is obtained more rapidly. A bank loan can take weeks or months, but if you have good credit clients, the invoice factoring process can be completed in a matter of days.
- Your credit score is not taken into account. Your business or personal credit is irrelevant with invoice factoring because your customers pay the investor.
- There are no capital restrictions. Bank loans limit the amount of cash you can borrow, but invoice factoring allows you to continue converting invoices into cash as long as you have creditworthy customers.
Bank loans require borrowers to pay a portion of the principal plus interest on a regular basis until the entire amount is paid. Bank loans offer several significant advantages:
- You don’t require dependable consumers. Invoice factoring is dependent on the availability of invoices from a suitable customer base. A bank loan may be a better alternative if you require more money than your invoices can give.
- Banks offer numerous loan choices. If you have strong credit, you may frequently negotiate lower interest rates and more flexible payment plans.
- Bank loans safeguard client information. A bank loan does not compel you to give another entity your customer information, like invoice factoring does.
The benefits and drawbacks of revenue-based financing
Benefits
- Revenue-based loans are now available to a broader range of firms and business owners. Because revenue-based loans are based on a company’s projected income, they do not rely on corporate cash flow, personal assets, or personal credit. As a result, they are usually more accessible to firms and business owners that do not qualify for traditional funding.
- Adjustable in terms of monthly revenue. A revenue-based loan requires you to pay a percentage of your monthly revenue, allowing the payments to be flexible with your monthly business cash flow.
- Business owners are not required to exchange ownership for capital. In contrast to equity financing, revenue-based lenders do not require any shares in exchange for funding. This permits a business owner to keep complete control of their company.
Drawbacks
- They may cost more than standard loans. Be aware of the payback cap and, if possible, compare it to interest rates on regular loans. Consider a traditional loan of the same amount with a 6% fixed interest rate, using our earlier example of a typical repayment ceiling of 1.1 on a $100,000 loan. Your total repayment amount for that loan would be $106,000.
- They can be problematic if your monthly expenses are significant. Monthly payments on a revenue-based loan might deplete your financial flow. If your company has high monthly expenses, even if it also has significant earnings, you might be better off with a loan with a set monthly payment.
- Revenue is required. This may seem apparent, but it bears repeating: a revenue-based loan requires revenue, usually a substantial amount of it. Because you are repaying a small portion of your monthly revenue, a lender will most likely want a particular minimum quantity of monthly revenue.
Alternatives to revenue-based financing
Invoice financing
Invoice financing may be preferable if your company is not a startup and depending on the nature of your firm. You secure your loan against future invoices with the help of invoice financing, which functions similarly to revenue-based lending. Business-to-business (B2B) companies are the only ones often eligible for this sort of loan, as repayment is based on invoices rather than gross sales, which fluctuates more frequently with seasonal firms.
Startup loan
If you’re in the market for startup funding, a revenue-based loan might not be your best bet. A starting loan from a bank or online lender may be more expedient, convenient, and inexpensive if you have solid personal financials and collateral.
Business line of credit
A company line of credit is another option to explore if you need a loan but want more repayment leeway. A business line of credit is similar to a credit card in that it is revolving and interest is only accrued on the funds actually used. Once you’ve paid back your initial loan, you’ll be eligible for additional borrowing. In some cases, a line of credit can be a reliable solution for entrepreneurs’ short-term cash flow needs.
SBA loan
If your company has had trouble getting a conventional bank loan, you may want to look into SBA loans as an alternative. The Small Business Administration does not directly give loans to businesses, but it does guarantee a portion of loans made through private lenders. This means that SBA lenders are more likely to extend credit to high-risk enterprises or to those whose own financial situations are less than ideal.
Summary
Think about the long-term consequences of any financing option before committing your company to it. A loan is a loan, regardless of the circumstances, and must be repaid. It may appear that there are less restrictions on revenue-based financing, yet using the money carelessly can lead to disastrous results.
While jeopardizing personal assets or selling off a portion of your firm is never a good idea, revenue-based financing is another tool in the entrepreneur’s toolbox that can help you build your business, hit your stride, and advance to the next level.
