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What is Revenue-Based Financing?
Revenue-based financing (RBF) is a fundraising method where investors provide capital to a company in exchange for a specified percentage of the company’s ongoing total gross revenue. It’s an appealing choice for businesses because it enables them to raise capital without giving up equity or pledging assets as collateral.
The structure of RBF can vary. But, typically, the company makes monthly installment payments at a fixed percentage of the overall revenue. The duration for repayment can range from three to five years, but this can vary based on the company’s sales performance.
For example, if a company arranges a deal to receive $1 million in exchange for a portion of its revenues, it might agree to pay 2.5% of its monthly revenue, up to a multiple of the original amount to compensate the investors for the risk involved. The repayment amount is usually capped at a certain multiple of the initial loan, usually 1.35 to 3 times its value.
From the investor’s perspective, RBF offers the opportunity for lucrative returns. However, it’s important to note the repayment rate is directly tied to the company’s revenues. If the company’s performance declines, so will the repayment rate. For that reason, it’s particularly suitable for companies with strong gross margins that generate recurring revenue (e.g., SaaS companies).
- Royalty-based financing
- Revenue-based loan
- Revenue-based funding
- Revenue financing
- Revenue share financing
How Revenue-Based Financing Works
Broadly, revenue-based financing works through a straightforward (though unique) process. We can summarize it in the following steps:
- Capital investment. An investor or a group of investors provides capital to a company (but not as a traditional loan nor in exchange for equity in the company).
- Revenue percentage agreement. In return for the capital, the company agrees to give the investor a fixed percentage of its gross revenues each month.
- Repayment structure. The company repays the invested capital through payments based on monthly or annual revenue. The amount paid each month varies as it is directly tied to the company’s revenue for that month.
- Repayment cap or term. There is usually a cap on the total amount to be repaid, often set as a multiple of the original investment (e.g., 1.5x or 2x the initial amount). Alternatively, the repayment might continue until a specific term is reached, such as a number of years.
Revenue-Based Financing vs. Traditional Bank Loans
Revenue-based financing is quickly gaining popularity as an alternative to traditional bank loans. Here are some key differences between the two:
- Traditional bank loans often require a high credit score, whereas RBF typically does not.
- Bank loans usually require collateral for approval, while RBF does not.
- Bank loans have fixed repayments and interest rates, whereas RBF payments are based on a percentage of revenue.
- RBF is normally faster to secure compared to bank loans, which can take weeks or months for approval.
- RBF normally has flexible repayment terms, structure, and duration.
While many of these seem like advantages of revenue-based funding over traditional bank loans, there are also some drawbacks to consider.
RBF can be more expensive in the long run due to its higher interest rates and longer repayment terms. It’s also less predictable, since the company’s revenue will fluctuate from month to month.
Types of Revenue-Based Financing
We can categorize revenue-based financing into two types: true revenue-based financing and receivables financing.
True Revenue-Based Financing
This is a loan that comes with either fixed monthly repayments or repayments as a percentage of cash receipts. The repayments fluctuate with the company’s revenues, offering flexibility.
This type includes two sub-categories:
- Receivables Factoring: This involves the sale of individual invoices to an investor or entity. If a specific contract sold under this arrangement falls through, it must be replaced with another.
- Merchant Cash Advances (MCA): Here, the entire business, including its fundamentals like Annual Recurring Revenue (ARR), Burn, and Cash in Bank, is evaluated. Businesses receive a discounted cash advance and repay it through equal installments over a period, typically 6-18 months, without interest.
Characteristics of Revenue-Based Loans
By design, revenue-based loans have a few key characteristics that distinguish them from other types of financing:
- Principal repayment. Unlike traditional loans, revenue-based loans don’t have a fixed principal amount to be repaid each month. Instead, the amount paid is a percentage of the company’s total revenue for that month.
- Interest rates. RBF loans typically have higher interest rates than traditional loans due to the risk associated with investing in startups or small businesses.
- Collateral-free. Revenue-based loans do not require collateral to secure funding, unlike bank loans. Instead, they use the company’s future revenue as collateral.
- Flexible repayment terms. RBF loans usually have flexible repayment terms that can be adjusted based on the company’s performance and cash flow.
- No ownership dilution. Unlike equity financing, RBF does not require the business owner to give up any percentage of ownership in the company.
Typical Requirements for Revenue-Based Financing
The typical requirements for obtaining revenue-based funding vary by provider, but there are some general criteria your business can expect to meet before qualifying.
Revenue and Profitability
Investors want to know for sure there will be future revenues before making this kind of investment. So, you’ll generally need to prove a reliable and predictable revenue stream.
That’s why RBF is particularly suited for businesses with recurring revenue models. And it explains why they’re so popular in the SaaS vertical.
Minimum Revenue Thresholds
Many RBF providers have minimum revenue requirements. For example, some might require a minimum of $100,000 in monthly recurring revenue (MRR) over the past six months.
Although RBF is common among startups, it is not suitable for businesses in the earliest stages. It works best for businesses that have generated predictable revenue for at least 6 months. This requirement helps investors to gauge the stability and potential long-term success of the business.
Runway and Cash Flow
Companies should have a reasonable amount of cash runway determined by their current cash balance and monthly net burn rate. This indicates the company’s ability to sustain operations and manage repayments in the short to medium term.
Location and Banking Requirements
Some RBF providers may have specific geographical requirements, such as being domiciled in a particular country and having a bank account in that country. Generally, this is because it makes disbursing and collecting payments easier for the provider.
RBF is generally best suited for high-growth businesses — AI, software development, and cloud computing to name a few. These businesses are likely to benefit the most from the flexibility and scalability that RBF offers.
Other Financial Metrics
Lenders might also evaluate other financial metrics such as Customer Acquisition Cost (CAC) payback period, the Return on Investment (ROI) from advertising and other customer acquisition channels, and the business’s overall liquidity.
Advantages and Disadvantages of Revenue-Based Financing
The biggest advantage of RBF is its flexibility, as mentioned above. Instead of providing collateral or dealing with the rigidity of a bank loan, the ability to access capital solely based on the business’s current (and future prospective) success is hugely advantageous.
A huge trap SaaS founders fall into is over-dilution. So, another advantage RBF offers is the ability for founders to maintain a larger percentage of equity in their company. This also means that you’re not sacrificing control over your business (which could bite you in the long run).
RBF also offers a safety net for businesses before they’re able to obtain traditional loans. For startups and small businesses that are still working on establishing credit and revenue history, RBF can be a viable option in the meantime.
A big disadvantage of RBF is the unpredictability in payments you have to make each month. Unlike traditional loans where you have a fixed monthly payment, RBF requires repayment as a percentage of revenue, which can make budgeting and forecasting more challenging.
Additionally, the higher interest rates associated with RBF can make it an expensive option for businesses in the long run. Some providers may also include additional fees and charges, further increasing the overall cost of financing.
Finally, the lack of ownership dilution can be seen as a disadvantage for investors. Since they are not obtaining equity in the company, they do not have a direct say in decision-making processes and cannot benefit from a potential sale or exit of the business. This only incentivizes them to focus on the company’s revenue and profitability, potentially hindering long-term growth strategies.
Use Cases for Revenue-Based Financing
This form of financing is especially attractive to:
- Growth-stage companies that are increasing their headcount (primarily salespeople)
- Companies launching a new product or implementing a GTM strategy
- Businesses preparing for large-scale sales execution or a huge marketing campaign
- Business owners who don’t want to give up equity in their company
- Business owners who don’t want to guarantee a loan
- A company that isn’t large enough for VC funding but still needs capital to scale
- A company that has not yet established credit or a strong financial history but has potential for significant growth
- Companies that have already raised a round of funding and are looking for alternative options to traditional debt financing
Alternatives to Revenue-Based Financing
1. Equity Financing
Equity financing is a method of raising capital where a company sells shares of its stock to investors in exchange for funding. This is a popular option for startups and high-growth companies, as it does not require repayment or interest payments.
It’s one of the best alternative financing options because it provides you with capital without incurring debt. But, there are no recurring payments like RBF.
However, this option means giving up a percentage of ownership in your company. Since it requires your investor to purchase equity in your company, it also requires you to have a solid track record, product, or idea.
2. Debt Financing
Debt financing is when a company borrows money from an outside source with the promise to repay the borrowed amount plus interest. This is a popular option for established businesses with a strong credit history and reliable cash flow.
While debt financing offers lower interest rates compared to RBF, it requires collateral or a personal guarantee from the business owner. It also involves fixed monthly payments, making it less flexible than RBF.
With crowdfunding, businesses can raise capital by asking a large group of people to each contribute a small amount of money towards their funding goal. This option has been popular for a while — Oculus and thousands of other successful companies started with a Kickstarter campaign.
Crowdfunding allows businesses to reach a wider audience and validate their product or idea in the market. But it requires extensive marketing efforts because the success of the campaign depends on reaching a large number of people. It’s best for businesses that are just getting off the ground and don’t have much revenue to show for their potential success.
4. Angel Investing
Angel investors are wealthy individuals who invest in startups and early-stage companies in exchange for equity. They also offer guidance and mentorship, which can be valuable for growing businesses.
The amount of equity varies from deal to deal, but it usually falls between 5-25% of the company. The biggest advantage to angel investors is their passion and expertise — they truly want to help the companies they partner with (and the people behind them).
That said, finding the right angel investor can be challenging, and the equity deal doesn’t always favor the founder. This is especially the case if they end up growing a valuable company and they have to dilute more in the future.
5. Venture Capital
Venture capital funding is the most well-known, though very few companies actually achieve it. VC firms use funds from high-net-worth individuals, companies, and other investors to invest in early-stage businesses with significant growth potential.
The amount of equity given up can be substantial (10-50%), but the trade-off is receiving a significant investment that can help your company grow at a rapid pace. On top of financial resources, VCs also provide valuable connections and experience to help your company succeed.
6. Grants and Subsidies
If your company is working on innovative projects, you might be eligible for grants or subsidies from the government. These are non-repayable funds that can help cover expenses related to research and development, marketing, and hiring.
If your business is in healthcare, environmental sustainability, or an innovative technology that benefits society, you almost certainly have opportunities for grant funding.
The great thing about grants is that they don’t require repayment or equity. But, the process of obtaining them can be lengthy and competitive.
One funding option, of course, is doing all the work yourself. This is impossible for some types of businesses (e.g., a medical device that requires rigorous testing, case studies, and approvals). But, If you’re building a niche SaaS product and you’ve saved a bit of money, you can potentially get by with smart decisions and what’s in your bank account.
Bootstrapping comes with a host of challenges, though. You’ll likely be working nights and weekends while you’re at another job, which ca be slow and frustrating. You’ll also have to deal with opportunity costs — you could be growing faster if you were spending more. And if you do go this route, make sure to save plenty of money for the future when you need it most.
8. Convertible Notes
A convertible note is a type of debt that can be converted into equity at a later date, typically during the next funding round. This type of financing allows early-stage companies to secure capital before establishing a valuation and issuing equity.
Convertible notes are attractive to both investors and founders because they offer flexibility. Investors get the potential for equity without taking on the risk of a fixed valuation, and founders get funding to grow their business without immediately diluting it.
9. Lines of Credit
Lines of credit are revolving loans from a bank or other financial institution that allow businesses to access funds as needed, rather than receiving the full amount upfront. This can be useful for managing cash flow and funding short-term projects.
The downside of lines of credit is that they often require collateral and have high interest rates. A credit card is the perfect example of this — if you get your business into credit card debt, there’s a good chance you’ll be paying it off for a long, long time.
Lines of credit also might not provide enough funding for larger projects or long-term growth. This depends on your creditworthiness and the terms of your agreement with the lender.
10. Peer-to-Peer Lending
Peer-to-peer lending is a combination between crowdfunding and traditional debt financing. It involves borrowing money from individuals or groups, rather than banks or other financial institutions.
Peer-to-peer lending is attractive for businesses that don’t qualify for traditional bank loans or have a lower credit score. These loans often have high interest rates (normally between 6% to 36%), but they can provide a lifeline for businesses that need funding quickly and don’t have many other options.
People Also Ask
What is an example of revenue financing?
Let’s say a firm agrees to provide you with $100,000 in capital. In return, they require a repayment cap of 1.5x and a monthly revenue percentage of 5% for repayment. With a repayment cap of 1.5x, you’ll need to pay back a total of $150,000 ($100,000 x 1.5). If your company generates $30,000 in a month, your payment for that month would be $1,500 (5% of $30,000).
What is the difference between factoring and revenue financing?
Factoring involves selling outstanding invoices to a third party for immediate cash, while revenue financing is obtaining funds in exchange for a percentage of future revenues. Factoring focuses on specific receivables, whereas revenue financing is tied to overall business performance.
What is the difference between venture debt and revenue-based financing?
Venture debt is a loan for startups, typically secured and with fixed repayments. Revenue-based financing involves raising capital in exchange for a percentage of ongoing revenues, offering flexible repayments based on business performance. Venture debt often requires collateral, whereas revenue-based financing does not.`