Entrepreneurs seeking to build their companies from the ground-up often face difficulties getting traditional debt-based financing. Banks, as well as many alternative lenders, approach business with firms that have at least six months of operation under their belt, and preferably 2 to 3 years. And that’s before you factor in such things as your creditworthiness.
One way round the debt-financing conundrum is to enter the world of investor financing. While equity financing has become the more well-known approach to investor financing, an alternative choice is revenue-based financing.
What Is Revenue-Based Financing?
Revenue-based financing grants investors a normal, ongoing percentage of a company’s income in return for a cash infusion. The investors receive scheduled payments until they’ve collected an agreed-upon amount of cash from the start up business.
Because this model depends on the company generating revenue, investors will want to see that you’re capable of producing the strong margins necessary to both keep growing and reimburse them. That means businesses thinking about a slower growth model, or those that may not be revenue-positive for an longer timeframe of time, are generally not a great fit for revenue-based financing, that is most often observed in the tech sector and adjacent businesses.
Funding amounts typically range from $50,000 to $3 million, with repayment expected in 3 to 5 years. Repayment caps, that are expressed like a flat multiplier, represent the quantity your investor is looking to reclaim from you. This rate typically ranges from x1.35 to x3, although higher caps aren’t unheard of. In some instances, the investors may instead use a date or sustained rate of return as cut-off points.
How Revenue-Based Financing Works
Let’s say you’re an enterprising tech entrepreneur with a great new app idea with explosive growth potential.
You’re even generating a bit of revenue from your early customers, but need money to develop. You approach an investor or investment group that provides revenue-based financing, and they like the things they see (your average monthly revenue has been $16,000, with strong gross margins). You’re not profitable yet, but you’re on course. The investor clears you for $1 million in revenue-based financing.
Interestingly, the $1 million generally will not be paid for you in a lump sum payment but will function a bit more like a credit line. Quite simply, you can draw upon it more often than once, so long as your overall draw doesn’t exceed the limit (note, however, there might be restrictions on when and under what circumstances you are able to draw).
Let’s say you were able to secure a cap of x2 and eventually use all of your “credit.” The quantity you’d be anticipated to repay would be $2 million ($1 million x 2). You and your investor choose a payment plan of 6% of the monthly sales, that have risen for an average of $40,000. You’d be paying around $3,200 a month. Assuming your revenue stays at this amount, you’d be paid off in a little over 5 years. If your revenue increases, you’d get paid off sooner. If it decreases, it might take longer.
Revenue-Based Financing VS Merchant Cash Advances
If you believe revenue-based financing sounds a little bit just like a merchant cash advance, you wouldn’t be too much from the mark. At their core, both of them are hedging on your future sales. Both are collecting a percentage of these future sales. Have indeterminant term lengths due to being revenue contingent. And both of them are relatively costly methods to finance your business.
That said, there are some differences between them, namely in terms of scale and scope. Merchant cash advances are usually based solely on your credit and debit card sales, not your revenue. Payments are usually made daily rather than monthly, and the expected time until money is usually much shorter. At the moment, merchant cash advances can also be found to more companies than revenue-based financing, which is commonly aimed specifically at high-growth businesses like tech startups.
Revenue-Based Financing VS Venture Capital
Revenue-based financing sits next to other kinds of investor-sourced financing like venture capital. Both have a tendency to heavily favor high-growth industries like tech, and both have a tendency to focus on entrepreneurs who normally would have trouble obtaining debt-based financing.
That’s where most of the similarities end. Investment capital is equity-based financing, meaning that you’re selling shares, or at best the option to purchase shares. Quite simply, you’re giving up some of your ownership in your company. This model typically assumes that you intend to sell your company anywhere between a five to seven-year window. Revenue-based financing, on the other hand, doesn't transfer ownership towards the investors. You’re not expected to market your organization (in fact, doing so may likely complicate your arrangement).
Venture capital financing often takes place on the number of rounds, with your company being able to view additional rounds of funding after they’ve hit specific milestones. Revenue-based financing generally isn’t as regimented, however, there might be conditions upon when you’re able to draw on your funds.
When Revenue-Based Financing Is Right (Or Wrong) For Your Business
Revenue-based financing, like most investor-based financing, is not as accessible as debt-financing. What this means is most businesses won’t have the luxury of deciding whether it’s suitable for them–it simply won’t be an option.
For companies that do fall under the revenue-based financing niche, you’ll need to weigh the chance cost of not implementing the cash from the financial cost of taking it. Will the growth financed with these funds, without the burden it wears your revenue, outpace the development you'd achieve without them?
Let’s look at some benefits and drawbacks:
Advantages Of Revenue-Based Financing
- You don’t have to give up equity inside your business.
- Payments really are a proportion of the revenue, so they increase or shrink together with your business.
- You’ll possess a longer repayment term than you’d have the ability to easily find on the alternative market.
- You might be able to access higher borrowing amounts than you would be in a position to with many loans.
- Your credit score and amount of time in business aren’t as big factors because they would be with lots of other kinds of financing.
Disadvantages Of Revenue-Based Financing
- Only certain types of businesses are entitled to this model.
- It’s expensive. You can easily wind up paying back double the amount as you borrowed, or even more.
- You won’t have the ability to raise as much money as you potentially could with investment capital.
- You need to have revenue.
- It’s not well-regulated.
What You have to Qualify
Besides having an industry supported by this kind of financing (namely tech), you’ll need to meet a few other qualifications.
You don’t have to be profitable, but you will have to be generating revenue with gross margins of 50% or more. Your gross margin is equivalent to your revenue minus the cost of the products you sold. Take that number and divide it by your revenue. If it’s 0.5 or higher, you might be a candidate.
But not too fast! You’ll also need to demonstrate that you’ve hit an income threshold for three or so consecutive months. That number may vary from investor to investor, but it’s usually somewhere around $15,000. You also don’t desire to be servicing any debt, so make certain you’ve settled any loans before seeking revenue-based financing.
And last, and surely most famously, you’ll must find a trader or investment group that provides revenue-based financing.
Where You Can Find Revenue-Based Financing
Using equity financing as a model, you may expect it to be very hard to find investors getting revenue-based financing. While it’s a relatively new model for financing with a limited number of players, there are a surprisingly many revenue-based financing investment groups that prominently advertise their professional services online. Including entities like Alternative Capital, Decathlon Capital, and Lighter Capital. Those having a strong online presence may even allow you to apply online. Typically, we recommend dealing with lenders and investors who're transparent and disclose the terms of their services upfront.
Learn About Other Financing For Businesses
With revenue-financing being an option only for a little minority of businesses, the majority of you will probably want some idea from the alternatives available to you should you don’t qualify. Luckily, you haven’t even come close to exhausting the possibilities.
Check out our additional features for entrepreneurs:
- How to obtain a Small Business Loan: The Step-By-Step Guide
- 6 Financing Choices for Up & Coming Entrepreneurs (Plus 4 Expert Tips To Keep)
- 14 Types of Alternative Financing for Small Businesses
- What is a Merchant Cash Advance?
