Securing financing to cover start-up costs or business expansion expenses is not always easy. Sometimes banks are hesitant to lend or require a personal loan guarantee. Venture capitalists (VCs) or angel investors, if you can find them, are looking for significant returns and a sizable portion of equity.
For the entrepreneur, this creates a challenging situation – how can you find financing for your business without losing equity or acquiring crippling debt?
For businesses looking for a middle ground between the world of conventional bank lending and the high-risk game of private equity investments, revenue-based financing could fill the gap. We’ll explore revenue-based financing and how to determine if it’s the right financing method for your company.
What is revenue-based financing?
Revenue-based financing is a loan that a business agrees to repay over time by pledging a portion of its future revenue to the funder until a fixed dollar amount is reached.
- Fixed Repayment Target: Revenue-based financing is a loan with a fixed repayment target that is reached over several years.
- Fixed Repayment Amount: Generally, income-driven financing comes with a repayment amount of 1.5 to 2.5 times the principal loan.
- Flexible repayment periods: with income-based financing, repayment periods are flexible; pay the agreed amount earlier if you can or later if you must.
- No loss of equity: with income-based financing, business owners do not sell equity or give up control.
- More hands-off approach than private equity: income-based finance firms work more closely with you than bank lenders, but take a more hands-off approach than private equity investors.
Not all finance firms handle income-based financing in exactly the same way. “They all do it a little differently, but the way we use revenue-based financing is to provide a sum of money … that the company agrees to pay back [as] a percentage of its revenue until it has paid back a fixed sum, ” said BJ Lackland, co-founder, and chief investment officer of IBI Spikes Fund. “The key to it all is that if a company grows faster than expected, we get paid over a shorter period of time, which means our ROI increases. Or it may take longer than we expect, which means ROI decreases.”
In general, revenue-based financing comes with a repayment amount of about 1.5 times to 2.5 times the principal loan. The fixed dollar target can be useful when a small business describes operations in its business plan. Still, it is essential to recognize that payments will come out of your business’ revenue stream and plan accordingly.
Understanding your financial obligations means maintaining best practices (which you should follow anyway), such as maintaining adequate financial reserves and budgeting conservatively.
When do companies look for revenue-based financing options?
Revenue-based financing attracts…
- Growth stage companies looking to hire additional salespeople.
- Companies in the midst of a new product launch.
- Companies are on the cusp of a large-scale marketing campaign.
- A company with an established market but not large enough for venture capitalists.
- Owners who do not want to personally guarantee a loan or sell stock.
Revenue-based financing is an alternative to debt financing and private equity financing.
- Debt financing: while debt financing allows owners to maintain full control of their businesses, sometimes they must offer personal assets as collateral, and even then, it is usually for a comparatively insignificant sum.
- Private equity financing: With private equity financing, founders are often reluctant to lose full control of their business. However, in return, they gain the resources, network, and expertise of their financing partner.
Revenue-based financing is the middle ground between these two options. While investors are unlikely to be on the board of directors or involved in operations, they maintain a stake in the success and growth of the company in a way that banks do not.
“Banks are primarily concerned with getting their money back and making a small return,” Lackland said. “Venture capitalists and angels are just looking for big upside. They make their money on 10x returns; they’re constantly looking for a home run. We’re in the middle; we like to call ourselves ‘VC lite.’ We’re here to help and talk, but we don’t look over our shoulder.”
Pros and Cons of Income-Based Financing
Like any financing option, income-based financing has benefits and drawbacks to consider.
Advantages
It is less expensive than alternatives. Revenue-based financing is less expensive than alternatives that involve equity. Other financing methods, such as angel investors and venture capitalists, require 10 to 20 times more in returns. In addition, those who provide revenue-based financing invest in your success, since the number of monthly payments they receive increases as your business succeeds.
You can stay in control. With revenue-based financing, you maintain ownership and control of your business and retain your equity. Investors will not gain power through board seats, etc., so you determine the direction of your business.
Monthly payments are flexible. Since monthly payments are based on income, slow months will not hinder your ability to pay. Your cost is tied to your income and, with good planning, should remain affordable.
You don’t have to personally guarantee the loan. Financing options, such as bank loans, require you to guarantee a loan, which puts your personal assets at risk. Income-based financing does not require that commitment.
You will raise funds more quickly. With income-based financing, you won’t have to make several pitches to get the money you need. Most lenders will make their decisions and offer financing within a month.
Cons
Must produce revenue. A business must make money to use this financing option, so it is not suitable for new businesses without a regular revenue stream.
Less money is available than with other financing options. Some financing options, such as VCs, are known to invest heavily in a business. Revenue-based financing provides about three to four months of a company’s monthly recurring revenue.
Monthly payments are required. No matter what, you must make the monthly payment. Cash-strapped businesses should consider this factor.
This sector has minimal regulation. Because there is little oversight of revenue-based financing, you should conduct careful research before entering into any agreement to avoid predatory lending.