Revenue-Based Financing

By March 30, 2020Financing
Coins on a surface represent financing for companies based on revenue generated.

To many capital-hungry startups, debt financing can seem like an unpalatable meal. The idea of making fixed payments every month is often a strong deterrent. However, many startups have adopted a more flexible form of debt financing—revenue-based financing. Originally popular among the oil & gas and entertainment industries, revenue-based financing has also been utilized by hundreds of tech and software-as-a-service (SaaS) startups. This article draws on interviews and published materials from two major revenue-based financing firms. This article will introduce the structure and qualifications of revenue-based financing, profile the companies that use it, and compare its pros and cons to those of other funding sources.

What is Revenue-Based Financing?

In revenue-based financing (RBF), investors lend cash to growing startups in return for a percentage of the company’s monthly revenues.1 This agreement allows borrowers to make flexible payments in proportion to their monthly revenues instead of fixed payments. RBF agreements are equity free, meaning RBF investors do not require equity stakes in the company, so the shareholders avoid dilution. In addition, RBF loans require no personal guarantees or specific collateral to qualify for the loan.

In RBF agreements, RBF investment funds (such as Lighter Capital, GSD Capital, and Decathlon Capital Partners) provide borrowers with a lump sum that is usually three to four times the borrower’s monthly revenue. The borrower then pays a percentage of its revenue each month to repay the debt. RBF investors require “repayment caps,” meaning the borrower would make debt payments until x times the amount of the original loan balance is paid off. For example, with a repayment cap of 1.5x, a borrower would make debt payments until 150% of the original loan balance had been paid. Included below is a table of RBF terms from Lighter Capital’s (2019):

Revenue-Based Financing Terms
Loan Amounts $50,000 to $3,000,000
Payment Terms 1% – 9% of monthly revenue
Repayment Cap 1.3x – 2.5x
Maturity 3 – 5 years

Qualifications for Revenue-Based Financing

RBF is generally limited to growing companies that have products or services with steady revenue streams. Many RBF investors are industry-agnostic, meaning investors focus less on the market segment where companies compete and focus more on financial statement performance and recurring revenue. When evaluating a company for RBF, investors require that companies meet certain gross and net margin thresholds and earn at least $15,000 of monthly recurring revenue. In addition, investors analyze a borrower’s burn rate (i.e., how fast a borrower uses cash), customer acquisition costs, and customer retention rates to ensure the company will have sufficient cash and recurring revenue to pay off the debt in the future.

RBF investors often require key-person life insurance2 on company executives for larger RBF loans. In addition, RBF investors require the right to a UCC-1 blanket lien on the company, which grants the investors the right to seize all business assets in the event of non-payment (the RBF investor’s position being second to any bank debt owed by the company). However, because RBF loans are secured by future revenues more than the collateral the company possesses, RBF investors will seek to help borrowers increase revenues before they seize business assets. Interviews with investors from two RBF firms detailed the minimum requirements that companies must have historically demonstrated to receive revenue-based financing.

Revenue-Based Financing Requirements
Annual Growth Rate 10% – 20% +
Minimum Monthly Recurring Revenue $15,000
Gross Margin Above 50%
Net Margin Above -50%
Non-payment Provision UCC-1 Blanket Lien

The requirements above represent minimum qualifications to obtain RBF. Some RBF firms require higher recurring monthly revenues or longer operating histories. Also, some RBF firms may abstain from certain industries and favor others. In return for these more stringent requirements, companies can receive greater cash amounts (up to $6 million, as one RBF investor shared).

Revenue-Based Financing Company Profile

To determine if RBF is right for your company, consider the profile of the companies who have benefitted from it the most. RBF works best for growing companies with high recurring revenue. Recently, business to business SaaS companies and technology service firms with subscription-based agreements and long-term contracts have benefitted from RBF because, while they are low on collateral, they have consistent future revenue to borrow against.

Startups with and without venture capital (VC) funding utilize RBF. One RBF investment firm stated that two-thirds of its RBF borrowers have no VC funding while the remainder use a mixture of venture capital, angel investing, and RBF to fund their growth. Many of the companies using RBF are in the beginning rounds of VC funding and use RBF to carry them to the next round. In some cases, RBF investors introduce borrowers to VC firms.

Pros and Cons of Revenue-Based Financing

When choosing their source of growth capital, most companies considering RBF compare its features to those of VC funding. Therefore, the table below compares the pros and cons of RBF and VC Funding.

Dimensions Revenue-Based Financing Venture Capital
Payments Requires monthly payments at variable amounts No monthly payments are required
Dilution Avoids dilution of original ownership and control Dilutes ownership and control
Cost of Capital Generally lower (avoiding the costs of dilution) Generally higher (including the costs of dilution)
Requirements Gross margin, net margin, monthly recurring revenue, and annual growth requirements Requires higher annual growth. Requirements will be more industry specific
Time Can be obtained within a shorter period Can be obtained within a longer period
Assistance Investors will advise minimally with possible board observation rights and connecting companies to VC funds3 Investors will vote on board decisions and provide market expertise and connections to key industry players
Amount Smaller amounts Larger amounts
Taxes The interest portion of debt payments are tax deductible No tax deductions because there are no monthly payments

While RBF can be an effective source of funding for the right startups, RBF is not the best source for every startup. RBF allows for flexible debt payments, but if there is monthly revenue, there is a required monthly debt payment. Investors require companies to meet margin, monthly revenue, and growth hurdles to qualify for RBF. Companies that don’t meet these initial requirements will find it difficult to make monthly payments.

Debt Alternatives to RBF

As you evaluate if RBF is right for your company, consider how RBF compares to other debt funding options. Among these options are venture debt and bank term loans. Venture debt will typically have a lower interest rate than RBF, but venture debt will cause some shareholder dilution. Also, venture debt is usually available only to companies that have received VC financing, which is not the case with RBF. Bank term loans, specifically small business loans, should also be compared to RBF. While bank term loans will offer lower interest rates than RBF, banks will often require that owners make personal guarantees that the debt will be paid. Often, when companies are looking for funds to purchase fixed assets that can generate stable cash flows, collateralized term loans can be preferable to RBF.

Conclusion

Revenue-based financing grants startups another option beyond venture capital to fund their growth. This type of financing works best for companies that demonstrate strong margins, stable growth, and recurring revenues. While RBF introduces companies to the risks of debt and provides less capital than VC funding, the flexible interest payments and anti-dilution components make it a popular financing method for many startups.



Resources Consulted


Footnotes

  1. The term “revenue” in this article is treated synonymously with the term “net cash receipts” because these amounts will be the same under cash accounting. However, companies that have adopted accrual accounting will be evaluated for RBF based on monthly net cash receipts.
  2. Key-person life insurance protects investors from the risks associated with an executive’s early death.
  3. RBF investors do not have equity in the company; therefore, they do not vote on board decisions. However, companies may ask RBF investors to advise on board decisions. Contrastingly, VC firms are given equity and control rights, thereby permitting VC firms to vote on board decisions and hold board seats. Ceding control to VC firms can reduce founders’ power, but with VC funding comes the benefits of more market expertise and connections to key industry players.
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Author Scott Williams

Scott Williams is from Seattle, Washington and will graduate with a Master of Accountancy degree from BYU in April, 2020. Over the past three summers, Scott has worked as an Accounting Clerk for two maritime companies and as a Risk and Financial Advisory Intern for Deloitte in Seattle. Scott also enjoys studying American military history and is currently co-authoring a book on the Mexican-American War.

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