In a financing landscape marked by venture capitalists and angel investors, early and mid-stage companies are right to be leery. The wrong source can leave an entrepreneur with sizable debt, stringent repayment requirements and unrealistic expectations for growth.
It should come as no surprise that many have turned to non-dilutive funds like revenue-based financing, which offers much-needed flexibility while allowing businesses to grow at their own pace. Better yet, borrowers don’t have to sacrifice ownership or control, nor do they have to kowtow to the demands of private equity firms that demand “growth at all costs.”
No more maxing out corporate credit cards. No more emptying out savings accounts. Revenue-based financing offers a far more sane approach to meeting a burgeoning company’s funding goals.
Of course, those beginning their financing journey might ask: Why not turn to traditional investment sources like banks? While banks have long served as a lending option for businesses, they have become increasingly hesitant since the ’08 financial crisis to lend to small businesses due to tighter federal regulations.
Similarly, businesses with a lack of consistent cash flow, insufficient collateral, an unfavorable debt-to-income ratio or a poor track record of generating profits over a long period, are likely barred from most bank lending options. Simply operating in an industry seen as “in decline” could affect the bank’s decision to hand out a loan.
By and large, banks overwhelmingly favor big enterprises, which is why so many companies have recently turned to alternative lending sources. As of 2018, 40 percent of private credit managers were actively lending to companies with an EBITDA lower than $25 million.
Non-dilutive, or non-intrusive, capital is just one category of funding provided by alternative lenders. Revenue-based funding is partisan to non-dilutive funding, meaning that it does not require the borrower to give up any ownership over their enterprise. Of course, interested borrowers should keep in mind these funds aren’t acquired free of charge, as certain restrictions are attached to some grants.
In this article, we’ll explore revenue-based financing, how it works, and its benefits for both borrowers and lenders. Without any further ado, let’s dive in.
What is Revenue-Based Financing?
Revenue-based financing refers to the practice of raising capital from an investment source, which in turn receives a portion of the company’s gross revenues in exchange for their investment.
Sometimes referred to as royalty-based financing, revenue-based lending enables investors to continue receiving a percentage until a preset total has been accrued. Typically, the predetermined amount is anywhere from three to five times the original investment.
Revenue-based financing is often considered a hybrid of equity and debt financing, which makes it particularly popular with startups, technology companies, and SaaS (software as a service) businesses.
Originating in the early ’90s, revenue-based lending was pioneered by venture capitalist Arthur Fox, an engineer-turned-investor. In 1992, he began the first small revenue-based fund in ’92, which was quickly followed by a larger fund in ’95.
Both funds returned an internal rate of return (IRR) of more than 50 percent with average recoupment of 28 to 30 months, quickly launching the model of alternative financing into worldwide fame.
Revenue-based loans were initially seen as a promising way to provide entrepreneurs in developing countries with rapid growth capital. In the wake of economic uncertainty, it offered a proven method to catalyze economic development in struggling industries and new enterprises alike.
But revenue-based funding has since expanded globally and gathered momentum due to its success in nations and companies of all kinds.
In 2000, there were just two publicly announced revenue-based funding deals. Less than a decade later, there were 27. Now, the lending option has become so popular and specialized that a single firm completed 500 deals by itself in 2018.
As revenue-based lending has grown in popularity, startups have increasingly turned away from venture capital, and for good reason. In contrast with revenue-based financing, venture capitalists often offer investments on the expectation of extreme, rapid, and often unhealthy early-stage growth.
In fact, it is not uncommon for venture capitalists to create an environment where growth occurs before demand can catch up. According to the comprehensive Startup Genome Report, premature scaling was the primary reason for failure across 3,200 startups. And 74 percent of startups that failed due to premature growth received two to three times more capital than was necessary.
The venture capital funding model puts companies on a fast track to grow through a surplus of available capital. Borrowers are led to believe that, if they just grow more quickly than the competition, they will succeed. And this excessive growth is accompanied by a miasmic spiral of larger and larger funding rounds.
Companies that don’t want to sell or go public after growth are not well-served by this model. Thankfully, revenue-based lending provides an attractive alternative to the “grow or die” mantra typical of venture capital firms.
Revenue-Based Financing: How it Works
During the initial phase, a company pursues a revenue-based loan from a lender, such as a business development company (BDC) or private equity firm, for a specific purpose. The company may need help scaling their operations, or financing marketing costs, or something else entirely.
Whatever the reason, a principal investment amount is agreed upon by both the borrower and the lender. The loan is then gradually repaid based on a fixed percentage of the company’s monthly revenue.
Revenue-based loans are not typically set with a target repayment date since the amount repaid each month depends on how much revenue is generated by the borrower. If the company experiences a slowdown in profits, the installments will be lower. And, if revenues are higher, the debt is repaid more quickly.
Before approving a loan, investors usually look at the typical expenses associated with the activity the business is trying to fund. They also factor in the amount of revenue the company is likely to generate in order to agree on a fair percentage for repayment.
Revenue-based loans are distinct from both debt and equity financing. Equity financing requires no set repayment but does dilute shares of the company to lenders, while debt financing entails higher risk because the loan amount must be repaid by a fixed date.
By contrast, revenue-based financing combines the most favorable features of debt and equity. Financing is provided in exchange for a percentage of future revenues. No company ownership is sacrificed, and there is less risk for the business since repayment isn’t fixed.
Typically, businesses borrow anywhere from $50,000 to $3 million, which depends on a number of factors including their annual revenue run rate (ARR) or their monthly recurring revenue (MRR). While ARR refers to how much the business expects to make in the future, MRR measures how much the business has consistently made over a set period of months.
Most investors set maximum loan amounts up to a third of the company’s ARR or four to seven times their MRR. The lender will calculate the loan amount courtesy of a repayment cap, which is often set between 0.4 and two times the principal investment, but varies according to the company.
The monthly repayment percentage will often be set at two to three percent of the business’ monthly revenue, yet it can run as high as 10 percent. The repayment cap is set in lieu of charging interest.
As you might imagine, the revenue-based financing model is particularly beneficial for companies based on SaaS practices or recurring subscription services. Businesses that provide goods to subscribed clients can facilitate growth initiatives, improve customer service efforts and explore new markets. Flexible financing can help these companies establish a sizable market presence without necessitating the outsized growth required by venture capital.
Examples of Revenue-Based Financing
For more clarity, it may be helpful to review some hypothetical examples of companies in their journey to secure revenue-based financing deals with investors.
First, consider the example of a medical technology company seeking to increase the size of a funding round without triggering premature equity dilution. A revenue-based loan satisfies that goal, providing flexible repayment and the ability to draw down funding later on.
Perhaps most compellingly, the upfront capital could be used to gain a greater market share and reach new healthcare facilities, without disrupting its ownership structure. This approach allows the company to focus on scaling their operations without worrying about changes in equity.
Alternatively, imagine a SaaS company that provides an integrated marketing platform for other small- and mid-sized companies, and is looking to expand itself. Revenue-based financing provides a runway for that growth, as the business benefits from the fact that repayments are dependent on its MRR, which is highly predictable due to the structure of the business.
Finally, consider a data user identification company that decides to go the revenue-based financing route to meet its goals of expanding into new markets and improving sales.
In an increasingly complicated era where consumers interact across many digital channels, the company shows very promising signs of future growth. The investor would be willing to provide a fairly termed revenue-based loan agreement with a high principal investment amount and additional capital disbursements upon meeting certain milestones.
Benefits for Lenders
While the benefits for borrowers are readily apparent, what’s in it for lenders? Perhaps most compellingly, revenue-based loans generate high returns when they are structured in the right way for the right companies.
For instance, one lender may decide to structure a revenue-based financing deal as debt and utilize an equity multiple of 2.5. If the borrower receives $2 million as the principal investment, they would pay off $5 million over time to the lender.
Depending on how quickly the loan is paid off, the fund’s investor would receive an internal rate of return (IRR) ranging from 25 to 40 percent. Of course, if sales drop, the IRR could fall closer to 5 percent.
The diligent investor rarely invests in a company that fails before expected repayment and may benefit handsomely from a borrower that repays quickly. Unlike traditional loans, revenue-based financing is incredibly durable in the wake of an economic crisis.
Consider the impact of COVID-19, for example. While some borrowers are struggling, they are still paying based on their lowered revenues, leading investors to expect a return of 20 percent on average.
Whether the economy is healthy or stoppered, lenders still expect to receive the same multiple on the principal loan amount. The difference simply lies in how quickly they start making a return on the initial investment.
Aside from metrics of profitability, the lender and borrower both benefit from sharing the same goals. Both want the company to be successful and for repayment to be quicker — the mutually advantageous loan structure prevents either party from getting burned.
Lenders will invest in a company dependent on a few key factors. Profit, gross margins, historic revenue, and projected earnings all serve in the final decision, as does the company’s business model and management structure.
Benefits for Borrowers
Revenue-based funding serves as a worthy complement to debt and equity financing because it allows borrowers to retain control and increase the distance between dilutive funding rounds.
Foremost, revenue-based financing is significantly cheaper than equity. Angel investors and venture capitalists usually expect a 10 to 20 times return on the initial investment, which presses companies to produce extremely rapid growth in a set period — even when that rate of growth may be bad for the business.
By contrast, revenue-based financing is based on a multiple of the principal loan amount — usually between 0.4 and two percent, though the amount varies according to the company — and is repaid as a percentage of revenue. This repayment structure aligns the lender and the borrower to not only grow the company, but to do so in a way that can sustainably weather economic volatility.
Once a revenue-based funding deal is secured, the borrower can grow on their own timeline and become established enough to seek out other forms of financing, if they’d like. Since funding is secured through the promise of future revenue rather than existing collateral, this is an especially attractive option for SaaS startups or new businesses with few assets.
However, since revenue-based loans are given based on a company’s historic revenue, it isn’t a great option for pre-revenue enterprises. Borrowers should also keep in mind that revenue-based loans are typically smaller than the loans provided by venture capitalists since the principal investment is usually a three to four times multiple of the company’s MRR.
Final Thoughts
For small- and mid-sized enterprises, the alternative lending space has quickly risen to prominence within the past decade. Startups and small companies alike find non-dilutive financing appealing, as it does not require any sacrifice of company control.
With alternative financing, companies can realize growth at a sustainable pace and are not beholden to the whims of an overly ambitious venture capital firm. Among the non-dilutive options, revenue-based funding is particularly attractive, owing to its flexibility and the fact that repayments are based purely on the revenue the company generates.
If you’re interested in engaging a business development company (BDC) that can provide the sort of flexible, borrower-friendly loan agreements mentioned above, check out Saratoga’s investment profile to see if your company is a good fit.