Small business owners working to build a new company from the ground up can often face difficulties securing additional working capital. Banks and credit unions would rather lend money to creditworthy companies that have been in business for at least two to three years, which leaves startup companies little room to secure the funds needed to grow and expand. Alternative financing has grown in popularity as it addresses the difficulties that smaller businesses face in raising capital. One alternative financing option that has taken off over the past few years is revenue-based financing.
In this article, we’ll discuss what revenue-based financing is, how it works, and how it can benefit your business.
Revenue-based financing, also referred to as royalty-based financing (RBF), is a funding solution in which investors or lending firms provide capital to a revenue-generating business in exchange for a percentage of future gross revenues. The payments vary depending on your company’s revenue. They can be collected from your bank account or subtracted directly from payment systems until the capital amount, plus a multiple, is repaid in full.
Revenue-based financing is one of the best ways to raise capital for your business without sacrificing part of your equity, or having to pledge your assets as collateral. This funding option is popular among startup businesses, particularly those in the software-as-a-service (SaaS) and technology industries.
People may assume that revenue-based financing is a combination of debt and equity financing, and while there are similarities between RBF and the two funding branches, there are a few distinct differences worth noting.
Revenue-based financing is similar to equity financing in that the money you receive comes from inventors or venture capital firms (VC) instead of a business lender. However, the investors that provide capital through RBF have no ownership in the business.
Like debt financing, revenue-based financing provides you with a lump sum, which you’ll need to repay through a series of payments. However, with RBF, you don’t need to pay interest on your outstanding balance or follow fixed repayment schedules. Instead, payments for revenue-based financing depend on your incoming sales revenue.
A firm’s decision to extend financing to your business is based on several factors, but in general, you’ll face fewer regulations compared to traditional debt financing. For instance, RBF doesn’t typically require a personal guarantee, and you don’t need to be profitable as long as you’re generating revenue with gross margins of at least 50%.
To calculate your gross margin: subtract the cost of goods sold from your revenue. Then take that number and divide it by your revenue. If you get 0.5 or more, you’ll likely qualify for revenue-based financing.
You’ll also need to show that you’ve reached a revenue threshold for at least three consecutive months. Keep in mind that this number may vary from investor to investor, but it’s usually around $15,000. You don’t want to service any debt while applying for revenue-based financing, so make sure to settle existing loans.
Once you know whether you qualify for RBF or not, you’ll need to find investors or investment groups that offer revenue-based financing. RBF is relatively new to the financing landscape, but there are several players that offer it, such as Decathlon Capital and Lighter Capital.
Investment firms with a strong online presence will often allow online applications. However, be sure to only deal with investors and lenders who are transparent with their terms, rates, fees, and services. Doing your research and sifting through your options will save you from potential financial distress.
To further understand revenue-based financing, here’s a concrete example:
Let’s say you’re running a tech business and you’ve launched a new software with high growth potential. You’re generating revenue from your customers, but you still need capital to take your business to the next level.
You apply for revenue-based financing and investors like what they see on the financial aspect of your business (average monthly revenues of $17,000 with strong gross margins). Your tech business isn’t profitable yet, but forecasts show that you’re on the right track. So, the investor approves your application and gives you $700,000 in revenue-based financing.
Generally, the investor won’t just hand over the $700,000 in a lump sum. RBF is often structured similarly to a business line of credit. This means you’ll be able to withdraw from your RBF more than once, given that your total draw doesn’t go over the limit. However, there may be certain restrictions on when and how you can withdraw, so be sure to ask your investor about this.
If you’ve secured a cap of x2 and you eventually used up your “credit,” you’ll need to repay two times the RBF, in this case $1,400,000. The investors set a monthly revenue percentage of 8%, which means your average repayment per month is around $1,360 if you have a monthly revenue of $17,000. Any unpaid amount at the end of your term is due in a balloon payment.
Again, the repayments are based on your revenue, so if your revenue increases, you’ll pay off your debt sooner. If it decreases, it will take longer for you to repay it.
To help you decide whether RBF is right for your company, here are some of the attributes that tend to go well with revenue-based financing:
There is a demand for your product or service. Since RBF is based on revenue, it makes sense that there has to be a demand for the products and services you sell. You’ll have a greater chance of qualifying if you have an established product/service, a growing audience, and proven demand.
Companies with a subscription-based business model. SaaS, B2B, B2C, and other businesses with a subscription-based model are likely to qualify for revenue-based financing. The consistent monthly recurring revenue from those subscriptions makes them a great candidate.
Apps and software with hybrid monetization. Tech companies rely on repetitive user engagement which generates revenue through in-app purchases and ads.
Revenue-based financing is not as widely available as traditional bank loans and debt financing. Most businesses don’t often have an idea whether RBF is the right fit for their company or not.
Even if your business falls into the categories mentioned above, it’s important to carefully weigh the pros and cons of revenue-based financing.
No personal collateral is needed. You don’t need to pledge your personal assets as collateral to qualify for RBF. This means you get to keep your assets even if you fail to repay the advance.
Retain control over your business. With revenue-based financing, you don’t need to give away company shares or a seat on the board. You’ll be able to retain full control over your business.
Easier application process compared to traditional bank loans. The repayment terms for revenue-based financing are more flexible compared to conventional loans. Application approval depends on your monthly recurring revenue, and investors have lenient requirements. For instance, some investors don’t ask for personal credit scores or business experience, making RBF an excellent financing solution for small businesses and startup companies.
Payments are based on monthly revenue. As previously stated, RBF is a flexible financing option since repayments are based on your monthly revenue. You don’t have to worry about debt payments exceeding your monthly income.
Smaller financing amounts. Revenue-based financing is an excellent option when it comes to giving revenue-generating companies a boost in working capital. However, the amounts you get through RBF are generally smaller in size compared to venture capital financing. Evaluate your business, and if you think you need more than what RBF offers, you might want to check out other financing options.
Monthly repayments. Monthly repayments based on revenue is an excellent option for companies that see a steady, positive monthly revenue. This makes RBF unsuitable for businesses that haven’t started selling products or services, as well as companies that want to get out of operating at a deficit.
Not available to all types of businesses. While the approval requirements for RBF are more lenient compared to standard financing options, this doesn’t mean that anyone can qualify. You need to ensure that your business is bringing in enough monthly revenue from month to month.
Once you’ve carefully weighed your options, you should have a clear idea of whether revenue-based financing is a good fit for your business or not.
While RBF is an appealing financing solution for startup companies, applicants need to meet a specific mold for it to work in their favor. You need to ensure that you have a steady stream of revenue. Subscription-based companies, SaaS, or tech companies might want to consider revenue-based financing.
With that said, RBF may not be a viable solution for other small businesses. You can further explore your funding options by checking out online business advances from alternative lending companies.