Revenue Based Finance
Revenue-based financing or royalty-based financing is a potential method of raising capital from a firm’s investors to meet business-oriented requirements. In exchange for the investment amount, individuals are entitled to receive a portion of the firm’s projected earnings, based on previous sales figures.
Investors continue to receive such pay-outs until they obtain a predetermined amount. Generally, the said predetermined amount is a multiple of their invested sum and tends to range between at least 3 to 5 times the principal investments.
Benefits of Revenue Based Financing
- Effective: It helps to meet immediate cash flow requirements. One can access funds through this option and facilitate their capital growth.
- Less Risky: Start-ups are not required to pledge collateral to avail revenue-based financing. Also, firm owners continue to retain their ownership and control over the enterprise and its managerial as well as financial decisions, which means there is no equity dilution.
- Flexible: Typically, when the revenue is less, the repayment amount is also less.
- Transparent: Financiers have a clear idea about repayments and the terms of clearing the same.
- Longer Repayment Term: The repayment term is usually relaxed and can be opted for long term. It allows businesses to pay off their debt without straining monthly revenue.
How does Revenue-Based Financing work?
There are firms that specialise in revenue-based financing. To start with, these companies look at parameters like revenues, cash flows, operating margins, scalability and growth potential among other things as part of their due diligence. Once convinced with the potential borrower’s prospects, they lend the required capital at a mutually decided rate of interest or fee.
Interestingly, this is quite similar to how an angel investor or even a VC would function, but what makes revenue-based financing different is the manner in which the funds are repaid by the borrower. The borrower commits to sharing a part of the business revenue with the lender. In other words, both the principal and the fee or interest that the lender charges, is returned from the revenues that the company earns during the normal course of the business.
Pros of Revenue-Based Financing
- Retain Control
Revenue-based financing is similar to equity financing in that funding is secured through investors or firms such as Venture Capitalists (VC). They differ, though, in that VC financing requires a share of the company or a seat on the board. Revenue Based funding does not require any control of the investment company. It leaves decisions and ownership entirely to the founder.
- No Personal Collateral
Revenue-based financing is similar to debt financing, such as a traditional bank loan, because repayments are made monthly based on a percentage of future revenue. The main difference is that RBF requires no personal guarantee as collateral against the loan, such as in a traditional business loan. Meaning, you do not have to risk any of your personal assets.
- Payments Reflect Revenue
RBF is the most flexible option in investor financing because, as stated above, the repayment schedule is based on a percentage of monthly revenue. Therefore, if business is light, the payment is light. There will never be a month where the debt payment is more than the monthly income.
- Quick Capital
Revenue Based Funding is approved on a much more flexible standard than traditional bank loans. Approval is based on the company’s monthly recurring revenue (MRR), and payment is set at the original loan amount plus repayment cap, traditionally somewhere between 1.3-3x.
RBF has lenient requirements, such as no specific personal credit score or business experience. Because of this, it is an excellent option for small startups such as subscription-based services and software as a service companies.
- Mutual Incentive
Unlike with VC funding, RBF investors have a mutual incentive for companies to produce revenue early in the investment. VC investors invest large sums of cash upfront but do not see a return until the back end. For RBF investors, the incentive lies in the fact that the higher the monthly revenue, the higher their monthly percentage.
Cons of Revenue-Based Financing
- 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.
- Smaller Check Sizes than VCs
Venture Capital is known for shovelling 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 grow, providing entrepreneurs access to more capital over time.
- 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.
Why Revenue-Based Financing?
Revenue-based financing is essentially a growth capital, availed to meet cash requirements related to
- Sales and marketing initiatives.
- Expansion of operational unit or scale of operation.
· Hiring talent and providing them with proper training.