It happens to a number of great, small businesses. Your offering is gaining traction in the market. Potential customers are lining up, and some would be huge sales. You see a great opportunity in front of you. But to take the business to the next level and capitalize on that opportunity, you need to scale your operation, add to headcount, and ramp up the spending. You need some capital, step in revenue based financing.
It’s more than your credit card can handle, so you turn to the bank for a loan – only to be rejected because you’re still viewed as too new, too risky. And as far as equity investors, such as angels and venture capitalists, you just don’t want to give up ownership and control at this point. And you can’t spend the next 3-9 months focused on fundraising – you have a business to build.
Aren’t their other options? Yes.
Entrepreneurs from around the United States are increasingly finding Revenue-Based Financing as an extremely suitable funding option, as it mixes the best aspects of equity and debt financing. Don’t know much about it?
Table of Contents
- 5 Things You Should Know About Revenue Based Financing (RBF):
5 Things You Should Know About Revenue Based Financing (RBF):
1. It’s a Loan, But Not Like The One You Get at a Bank
RBF is unique because it provides entrepreneurs with growth capital in return for the financer being paid a small percentage of future revenues. It’s technically a loan, but there are no fixed payments, no set time period for repayment, and no set interest rate. Doesn’t sound much like a regular loan? It’s not. Here’s how a $250,000 loan might work:
The Loan Principal: The investor provides $250,000 to the small company.
Payments: Every month, the company pays the investor a fixed percentage of revenue – let’s say 5%. (The percentage is fixed when the loan is funded, and typically falls between 1% and 10%.) If revenues in January are $100,000, then the company pays the investor $5,000. If February revenues are $80,000, that month’s payment is $4,000.
Loan Termination: The loan is fully repaid when cumulative monthly payments equal a fixed total dollar amount, called the “Repayment Cap.” The Repayment Cap is set when the loan is funded and typically equals 1.5 to 2.5 times the principal. For a $250,000 loan with a Repayment Cap of 2.0, the loan is fully repaid when cumulative payments equal $500,000. Most RBF lenders expect this to occur over 4-5 years, but how long it takes depends entirely on the growth and performance of the company.
The Kicker: Like most non-bank debt, most RBF investors expect some upside kicker, such as warrants.
2. It Aligns The Entrepreneur’s Success With the Investor’s Success – The Best of Equity and Debt
Like equity, the RBF investor’s ROI depends directly on the success and growth of the company. Unlike equity, RBF investors don’t own shares and don’t take board seats, so all control and ownership are left entirely in the entrepreneur’s hands.
Why does the investor’s ROI depend directly on the company’s success? Think of the math: If the company grows more quickly than expected, the investor receives the Repayment Cap ($500,000 in the example above) faster than anticipated – perhaps in 3 years instead of the 5 years. This greatly increases the investor’s ROI.
So RBF investors have every incentive to help the company grow, either through bringing sales opportunities, or additional financing, or helpful advice.
3. It’s Not for Every Small Business
Revenue-Based Financing is not the best financing option for every small business or entrepreneur. For example, businesses with low gross margins are not well-suited for this funding model because the investors are being paid a percentage of revenue, effectively compressing gross margins even more. High gross margin businesses – such as software/tech, and specialty services and manufacturing – are typically better fits because their high margins and scalable businesses allow for significant increases in cash flow from growth, even while paying the investor a percentage of revenue.
4. Revenue-Based Financing Isn’t a New Concept
Revenue-Based Financing was very popular in the early-to-mid 1900’s, especially in the oil and gas industries where it was common to provide large sums of cash up-front in exchange for a percentage of the royalties generated. Today the RBF model is still commonplace in entertainment (think music and movies), publishing, and pharmaceutical industries.
5. It’s More Expensive Than Bank Loans, Less Expensive Than Equity
A bank will charge you 6-9% interest plus fees. It’s the least expensive money around. But banks are highly risk averse, so many small businesses don’t qualify for bank financing without the entrepreneur putting her house up as collateral.
Equity investors are looking for 10 times their investment – super high risk, super high return.
Revenue-Based Financing sits in the middle, more expensive than a bank and cheaper than equity. RBF investors typically target a 15-30% annual return, ultimately receiving 1.5-2.5 times the original investment (principal).
The other “cost” entrepreneurs frequently don’t take into account is the amount of time it takes to raise funds. It’s grueling work, taking you away from building the business. RBF investors often act more quickly than VCs. Banks are highly regulated and risk-averse, so it’s hard for them to respond quickly for a small business. And VCs make huge bets of time, money and reputation on only a few companies, and therefore, need to be extremely selective. RBF investors aren’t regulated like banks and can work with far more companies than VCs, so they tend to act more quickly, allowing the entrepreneur to get back to business.