What do you do first when you’re looking for funding? Debt and equity-based funding have historically been the go-to options for most entrepreneurs, but securing financing to cover startup costs or business expansion expenses is not always straightforward. Banks may be hesitant to lend or may require a personal loan guarantee. Venture capitalists (VCs) or angel investors, if you can find them, want big returns and a big piece of equity. This makes things difficult for the entrepreneur. How can you raise money for your company without giving up equity or taking on unbearable debt? In the last few years, revenue-based financing has become a popular way for businesses to get the money that falls between traditional bank loans and the high-risk world of private equity investments. In this blog, we’ll talk about what revenue-based finance is, how it works, if it’s right for your business or not, and more.
What is Revenue Based Financing?
Revenue-based financing is a type of business financing in which lenders provide funds in exchange for a percentage of future revenues. This type of business financing combines the flexibility of debt financing and equity financing.
In this arrangement, the interest payment is contingent on a company’s performance. A business is not required to dilute its shareholding for the benefit of a third party. Certain parameters are also agreed upon, such as the amount of the loan, the repayment schedule, the percentage of revenue to be shared with financiers, and the payment frequency (daily, weekly, or monthly).
If a business borrows Rs. 25 lakhs, its monthly turnover will determine the contract terms. An agreed-upon percentage of revenue will be paid as interest. For instance, if the percentage is set at 5%, then if the monthly sales are Rs 1 crore, Rs 5 lakhs in interest would be due. If the turnover falls to Rs. 80 lakhs, Rs. 4 lakhs will be required as interest payment.
Benefits of Revenue Based Financing
1. Cheaper than equity
With expected returns of 10X to 20X, angel and venture capital funding are the most expensive sources of capital for a successful startup.
2. Retain more ownership and control
When it comes to revenue-based financing (RBF), investors usually do not take equity. Consequently, there is no dilution of ownership for founders and early equity investors. In addition, RBF investors do not serve on a company’s board of directors or impose restrictive financial covenants. Founders can maintain control and steer the organisation towards their vision.
3. No personal guarantees
Due to the high-risk nature of startups, bank loans require personal guarantees from founders. This necessitates founders to risk their assets, such as a home or car. Under RBF, founders can relax knowing that no personal guarantees are required.
4. No large payments
Monthly payments are determined by a percentage of monthly income. This means that if you have a bad month, your monthly payment will reflect that, and you won’t have to make a big payment you can’t afford.
5. Shared alignment towards development
As part of their “growth-at-all-costs” strategy, venture capitalists overinvest in companies until they self-destruct. Because RBF has a flexible repayment schedule, investors gain more as a company’s growth accelerates. Consequently, both the entrepreneur and the investor share a common objective for the company’s revenue growth.
6. Faster funding timeline
It may take months or even years to close a deal after making a pitch to venture capitalists. Lenders can provide funding in as little as four weeks because RBF investors don’t demand that businesses achieve hyper-growth or significant equity exits.
How does Revenue Based Financing work?
A borrower is required to guarantee an investor a portion of their revenue under revenue-based financing. A borrower ultimately pays back the principal sum and a portion of the profit to the investor.
For instance, a business’s monthly revenue is Rs. 10 lakhs. Accordingly, its annual revenue is calculated to be Rs. 120 lakhs. The investor will evaluate the business based on several parameters, including operating margins, scalability, working capital management, and future growth potential.
If an investor provides a loan of Rs. 20 lakhs in exchange for a 10% revenue share, the investor will receive a 10% revenue share. The borrower’s monthly revenue amounts to Rs. 50 lakhs. Therefore, the total payout to the investor will amount to Rs. 25 lakhs (Rs. 20 lakhs plus 10% of Rs. 50 lakhs)
Revenue Based Financing vs. Traditional Financing
| Particular | Revenue Based Financing | Traditional Financing |
| Value | The loan’s value is based on the company’s revenue and profitability. | The value of a loan is determined by collateral assets, personal guarantees, and business performance. |
| Security | No collateral is needed to get a loan through revenue based financing. | The standard loan requires collateral in the form of tangible assets or personal guarantees. |
| Repayments | Lenders get a set percentage of income in the form of interest until the loan amount is paid back. So, repayments depend on how well a business does. | Lenders are paid a fixed rate of interest on the principal loan. At the end of the loan period, the principal is repaid. Repayments are set and not based on how well the business does. |
Cons of Revenue Based Financing
1. You must produce revenue
This financing option requires a business to generate income, so it is unsuitable for startups without a regular income stream.
2. Fewer funds are available than with alternative financing options
Some funding options, such as venture capital, are known for making substantial investments in a business. Three to four months of a company’s monthly recurring revenue are provided by revenue-based financing.
3. There must be monthly payments
No matter what, the monthly payment must be made. Cash-strapped businesses should consider this factor.
4. This industry is lightly regulated
You must conduct thorough research before signing any agreements because there is little regulation of revenue-based financing, which makes it difficult to avoid getting a predatory loan.
Is Revenue Based Financing right for you?
Revenue-based financing is not the optimal option for every business. Before pursuing it, you should consider the following:
- Your organisation 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.
Before committing your business to any form of financing, you must consider its long-term responsibilities. A loan is a loan, which necessitates repayment. Regarding revenue-based financing, there may be fewer restrictions on the money, but treating it carelessly is a recipe for disaster.
Conclusion
From the perspective of an investor, revenue-based financing offers the opportunity to earn lucrative returns. However, an investor should be aware of the risks associated with the financing model, as the repayment rate is directly proportional to revenues. If the company’s revenues decline significantly, the repayment rate will also decrease proportionally.
Moreover, the revenue-based financing model is not suitable for all businesses. The model is only applicable to companies with sufficient revenues. In addition, a company that intends to utilise revenue-based financing must have healthy gross margins to be able to repay the investment. Generally, revenue-based financing is optimal for SaaS businesses.
FAQs
1. What is Revenue Based Financing?
Ans: Revenue-based financing is a type of business financing in which lenders provide funds in exchange for a percentage of future revenues. This type of business financing combines the flexibility of debt financing and equity financing.
In this arrangement, the interest payment is contingent on a company’s performance. A business is not required to dilute its shareholding for the benefit of a third party. Certain parameters are also agreed upon, such as the amount of the loan, the repayment schedule, the percentage of revenue to be shared with financiers, and the payment frequency (daily, weekly, or monthly).
2. How does Revenue Based Financing work?
Ans: A borrower is required to guarantee an investor a portion of their revenue under revenue-based financing. A borrower ultimately pays back the principal sum and a portion of the profit to the investor.
For instance, a business’s monthly revenue is Rs. 10 lakh. Accordingly, its annual revenue is calculated to be Rs. 120 lahks. The investor will evaluate the business based on several parameters, including operating margins, scalability, working capital management, and future growth potential.
If an investor provides a loan of Rs. 20 lahks in exchange for a 10% revenue share, the investor will receive a 10% revenue share. The borrower’s monthly revenue amounts to Rs. 50 lakh. Therefore, the total payout to the investor will amount to Rs. 25 lahks (Rs. 20 lahks plus 10% of Rs. 50 lahks)
3. Why use Revenue Based Financing instead of debt financing?
Ans: Revenue-Based Financing (RBF) may be preferred over debt financing due to its flexibility in repayment tied to revenue, absence of fixed interest rates, shared risk with the business, faster access to capital, potential for long-term partnership, and no dilution of equity.
