What Is Revenue-Based Financing?

With revenue-based financing, a company promises to pay back a loan over time by giving the financier a portion of its future profits. Investors generally demand the payback to be a multiple of the investment principal.?

Revenue-based financing is not handled uniformly by all lending companies. According to BJ Lackland, co-founder, and chief investment officer of IBI Spikes Fund, "Everyone does it a little bit differently, but the way we use revenue-based financing is to provide a sum of money which the company agrees to pay back as a percentage of their revenue until they've paid a set sum." The key to the whole operation is that if a firm expands more quickly than anticipated, it pays in less time, which increases the ROI. Or it can take longer than anticipated, resulting in a lower ROI.?

Revenue-based financing often has a repayment amount that ranges from 3 to 5 times the loan's original balance. That is, if the creditor lends you $1,000 as revenue-based financing, they can ask the total repayments to be $3,000 or $5,000. Therefore, when a small business pursues this type of funding, it is important that it describes the estimated revenue and profit in the business plan as accurately as possible, preferably with a predictable stream of cash flows every month. As well, forecasting clear future financials helps a company make plans accordingly to ensure meeting all its obligations.?

Why do you need revenue-based financing?

If you need funding for your business's expansion or want to keep it liquid, revenue-based funding is an option to consider. Here are a few real-world examples of revenue-based financing: your company is growing quickly, requiring more money for revenue-related costs like wages and advertising; a significant order comes in for your company, but you don't have the cash on hand to fill it, or you prefer to have enough dry powder on hand for future investment.?

How does revenue-based financing work?

Revenue-based financing is different from debt financing for a range of reasons. First of all, even though an organization relying on this method of financing will have to make regular payments to investors, there are no fixed principal payments and interest charged on the unpaid balance. This is because payments to investors are directly correlated with how well the business is doing, as payments depend on the business's income. In other words, the royalty payment to an investor will be decreased if sales decline in any given month. Similarly, payments to the investor for a specific month will grow if sales in that period rise.

Additionally, given that the investor does not acquire a share of ownership of the company, revenue-based financing is also distinct from equity financing. And because of the characteristics of revenue-based financing, it is sometimes viewed as a combination of debt and equity financing.?

Finally, revenue-based financing resembles account receivable-based financing in certain aspects. Under this kind of asset-financing agreement, a company takes advantage of its receivables—unpaid bills or other money owed by customers—to obtain funding. The mechanism of this type of funding is that an amount equal to the diminished value of the receivables will be paid to the company. Also, the quantity of funding the company receives is significantly impacted by the age of the receivables.?

Is revenue-based financing a loan?

Not at all. In truth, revenue-based financing varies from a loan in several respects. These respects include creditors not charging interest on the outstanding balance, repayments being proportionate to income rather than fixed, and recipients not having to provide the financier any collateral.

Revenue-based financing vs. debt financing?

The primary methods of obtaining corporate funding historically have been debt, as well as equity financing. However, there are considerable disadvantages to using the popular debt financing strategy.

To begin with, obtaining a business loan is challenging. Long application forms, mountains of paperwork, and never-ending email exchanges are enough to give you a headache. As well, to decide whether to offer a loan, creditors will consider your company's track record, credit history, and other variables. The approval procedure can go on for months, and some lenders will go so far as to demand a lien on the company's assets.

What about raising funds from venture capital firms or angel investors??

Equity fundraising may just be as taxing as debt financing, with all the investor pitches and outreach. Additionally, you will have to give up ownership and/or control over your company. Revenue-based financing, on the other hand, combines the best aspects of debt and equity financing while undermining their disadvantages. ?

Revenue-based financing vs. equity financing

The price of raising capital may be high if equity is excessively diluted. You forfeit some decision-making power when you relinquish a portion of ownership. While a portion of your company's revenue will be shared with investors, revenue-based finance is a non-dilutive funding option. In other words, you continue to own your company.

Given all the mentioned drawbacks of equity financing, revenue-based financing could be a more ideal option for your business, depending on your circumstances.

Conclusion

Small to medium-sized enterprises unable to access more traditional types of credit are most likely to use revenue-based financing. The cost of seeking revenue-based financing is forgoing a portion of the company's revenue, which is then distributed back to the investor. Additionally, financiers typically demand the payback to be three to five times the original investment principal.