Revenue-based financing, also known as revenue-share investing is a means of obtaining credit via leveraging estimated earnings. Read on to find out more about this alternative investment model.
Also known as royalty-based financing, Revenue-based financing is a capital-raising method wherein investors provide capital to a business in exchange for a portion of the business’s ongoing total gross revenue. While other conventional equity-based investments have been commonly used by investors, revenue-based financing is a more attractive capital-raising method for businesses as it offers added advantages.
With the help of revenue-based financing, companies can successfully raise the capital it requires without pledging a portion of the assets as collateral or sacrificing a portion of their equity. Additionally compared to debt & equity financing, the process for revenue-based financing is much easier & requires much less documentation.
Now let’s find out how revenue-based financing works and what benefits it offers.
How does revenue-based financing work?
Revenue-based financing is opted for by a company owner when he is not able to obtain loans from any financial institution or when the shareholders of the company are not willing to dilute their stakes by involving new investors by using equity-based financing. Suppose a business requires further expansion and needs to raise ₹1 Crore capital and there is no other option available for raising capital. In certain situations, the company needs to raise capital through revenue-based financing.
Here’s how the company has to operate. The company arranges a deal with XYZ Capital which specializes in this form of finance agreement. As per the deal, XYZ Capital will provide ₹1 Crore to the company in exchange for a part of the company’s total gross revenue. The company has to next make monthly payments to XYZ Capital (say 2.5% of the total gross revenue). Also, the company may have to pay an extra amount apart from the original amount to cover any risks.
How is revenue-based financing different from conventional Debt & equity-based financing?
When seen from a broader prospect, revenue-based financing seems similar to conventional debt financing in the sense that in both cases investors are entitled to monthly payments against their invested capital. But the difference lies in the fact that:
- In the case of revenue-based financing, there is no involvement in interest payments. Rather, the repayments are calculated using some multiple which results in a return amount that is actually higher than the investment made by the investor.
- Additionally, in a revenue-based funding model, companies are not entitled to provide any collateral to the investors.
- Contrary to an equity-based funding model, revenue-based financing involves no transfer of ownership stake.
- Also, the company is not entitled to provide any seats on the BOD to its investors.
Benefits of opting for revenue-based funding or financing
This alternative method of fundraising for startups as it comes with many benefits. Startup founders won’t have to share their ownership & can have full control over the business. Following is the list of top advantages of revenue-based financing:
Much cheaper than other funding models
Compared to Angel & VC funding models, revenue-based financing is much cheaper. It involves no expectations of 10 to 20 times returns from the investors.
Helps to retain maximum ownership and control over business
As mentioned above, revenue-based financing does not involve any equity ownership from the investors. In RBF there is no space for ownership dilution to the founders & initial equity investors.
As a result, the founders of the company have full ownership of the company and can have more control over the business and make decisions independently. Additionally, RBF investors do not take any seats on the board. All of these help the founders to stick to their vision and help the company achieve its long-term goals.
Elimination of large payments
Unlike conventional funding methods where you will have to pay a fixed amount to the investors, in RBF you are not burdened with paying a fixed amount to the investor. In RBF, the monthly payment structures are based on the percentage of the monthly revenue of the company.
Therefore if in certain months your revenue is not good, your monthly payment will reflect the same. The higher the revenue earned the higher will be the number of monthly installments. As a result, companies are not burdened with large payments even if they are running on losses.
No personal guarantees
As a startup when you take loans from banks you need to put your personal assets at stake. No bank will provide loans to startups without personal guarantees considering the risks associated with startups. However, in the case of RBF, personal guarantees are not required. Founders can remain burden-free.
Both investors and founder share a common goal
Investors’ returns increase as the company grows as RBF involves a flexible payment model. Therefore both the investors and the founder would want the company to grow. As a result, both would put extra effort into the company to help it grow.
Faster funding method
We all know how hard it is to pitch in front of investors when the company is just a startup. It takes months or even years to secure a deal. As RBF investors don’t have hyper expectations from the company, they can provide the funding much faster.
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Are there any drawbacks associated with revenue-based financing?
Well, every financing method has some or other drawbacks and revenue-based financing is no exception. The following are some drawbacks of revenue-based financing:
- This model does not fit pre-revenue startups. A company needs to show some revenue to convince an RBF investor. An RBF investor uses ARR or MRR metrics to determine the company’s growth and eligibility for the loan.
- Companies cannot expect huge checks from revenue-based funding. While Venture Capital involves a huge amount of investment for the companies even if it is in a pre-revenue stage, one cannot expect an enormous amount of cash through RBF deals. To be precise the capital won’t be more than three to four months of the MRR of the company.
- Startups might find it difficult to pay monthly installments in cash to the investors in the initial few months. Therefore while pitching startups needs to be careful about their financial status and future plans.
Revenue-based funding can be highly beneficial for an investor. Since it involves a flexible payment structure based on the total revenue collected by the company, investors can earn a good profit if the company grows and becomes profitable. The more the profit, the higher the paychecks!
However, an investor should be aware of the risks associated with RBF. When investing in a company through the RBF model, investors need to know the future plans of the company and evaluate the growth of the company using proper metrics.
It should also be noted that a revenue-based funding model is not appropriate for every company. A startup in its pre-revenue stage can’t go for revenue-based funding. The company needs to have strong gross margins so that it can repay its investors every month.
Did You Know?:
Despite being a relatively new segment in India, revenue-based financing has a big following in the US and Europe, where firms include Bigfoot Capital, Uncapped, Lighter Capital, Fleximize, and Decathlon Capital Partners.