Revenue-based Financing

Revenue-based financing or royalty-based financing (RBF) is a type of financial capital provided to small or growing businesses in which investors inject capital into a business in return for a fixed percentage of ongoing gross revenues, with payment increases and decreases based on business revenues, typically measured as either daily revenue or monthly revenue. This funding model is similar to a merchant cash advance, which is a lump-sum payment to a business in exchange for a percentage of future credit card sales or daily debit card sales. Like RBF, merchant cash advances do not require collateral or equity and are typically repaid within a short period of time, often within a few months to a year. Usually the returns to the investor continue until the initial capital amount, plus a multiple (also known as a cap) is repaid. Generally, RBF investors expect the loan to be repaid within 3 to 5 years of the initial investment.

Overview

RBF is often described as sitting between a bank loan, typically requiring collateral or significant assets, and angel investment or venture capital, which involve selling an equity portion of the business in exchange for the investment. In an RBF investment, investors do not take an upfront ownership stake (equity) in the business, usually taking a small equity warrant instead. RBF investments usually do not require a seat on the company's board of directors, and no valuation exercise is necessary to make the investment. Nor does RBF require the backing of the loan by founder's personal assets.

While revenue-based financing has been used to raise capital for SaaS products across the world via players like Novel Growth Partners, Big Foot Capital, Calm Company Fund, Lighter Capital, Unlimitd, it is now being utilised for D2C businesses as well. Players like ClearCo, Valerian Funds & Unlimitd are leading the way in RBF for consumer brands in the West, while newer startups like Klub are pioneering the same for consumer brands in the East.

History

RBF has long been used in the energy industries as a type of debt financing. In the late 1980s, Arthur Fox pioneered this funding model for early-stage businesses in New England. Seeing some initial success, he began a small RBF fund in 1992, which was found to perform on-par with expectations for the alternative assets industry, yielding an IRR of over 50%. In 2011, he began licensing his proprietary RBF financing model to enable new RBF funds to form.

The Revenue Capital Association is the trade association representing the RBF industry. Some firms have a geographic-focused model in the Mountain States. Other firms take a more nationwide approach.

Comparison

RBF can provide significant advantages to entrepreneurs and businesses. The nature of RBF, however, requires that businesses have two key attributes. First, the business must be generating revenue, as it will be from that revenue that payments are made. Second, the business should have strong gross margins to accommodate the percentage of revenue dedicated to loan payments.

The interests of an RBF investor align with the interests of the companies in which they invest. Both parties benefit from revenue growth in the business; both parties suffer when revenue declines. This is in contrast to a typical bank loan, which has a fixed monthly payment over the life of the loan regardless of business revenue. RBF helps manage rough months in the business by having a payment that traces revenue.

Cost of capital is an important consideration for entrepreneurs raising money. Usually the cost of capital in an RBF investment is significantly less than a similar equity investment, for several reasons: First, the actual interest rate on the loan is much lower than the effective interest rate required by an equity investor on their invested capital if the business should be sold. Second, legal fees are lower than with equity financing. Third, because the investment is a loan, the interest payments can often be a tax deduction for the business.

This cost of capital savings is a result of the RBF model and nature of the risk taken by the investor. Because the loan is making payment each month, the RBF investor does not require the eventual sale of the business in order to earn a return. This means that they can afford to take on lower returns in exchange for knowledge that the loan will begin to repay far sooner than if it depended on the eventual sale of the business.

RBF often is more expensive than bank financing, However, few early-stage businesses seeking growth capital will have an asset base to support a commercial loan. Most banks will therefore require a guarantee from the founders of a business that, in the event of default, the bank can pursue their personal assets.

References

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