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Financing: Revenue-Based Financing

  • Description:  
    • Revenue-based financing (RPF) is a financing arrangement where a company takes in cash now and pays back over years a percentage of monthly or quarterly top-line revenue (say 1 to 9 percent) until a fixed amount is paid back (usually a fixed multiple of the original cash provided say 2 to 3 times). It is sometimes known as royalty-based financing. One way to think about it is as more equity-like debt as the repayment is more variable.
    • Note: revenue-based financing is different than factoring or an accounts receivable line, in that it is a long-term instrument that is not specifically secured by existing revenues rather a promise to pay back out of future revenues.
  • Benefits:
    • Company – Control: like a lender, an RBF investor will have little to no formal control while the instrument is being paid properly or after. There are typically no board seats, no voting rights, and few to no blocking rights.
    • Company – Ownership: Little to no dilution although some RBF deals will have warrants or equity conversion features on sale of the company or if there is a future equity round.
    • Company – Optionality:  The founder retains the option to build a high-growth VC style business, a world-class company in a niche, or a lifestyle business
    • Company – Not Joining VC Treadmill: Compared to VC funding, there is less of an assumption and pressure to raise a future equity round.
    • Company – Flexible Payment Amounts: Compared to a traditional loan, the payment amounts are more flexible in that they automatically adjust to the resources available to pay. 
    • Company – No Personal Guarantee: Compared to a small business bank loan which often requires one, there is rarely a personal guarantee for RBF.
    • Company – No Valuation: For a vanilla RBF deal, the founder and the investor are not required to agree on a valuation of the business. While there is a discussion about revenue projections, there does not have to total agreement on those either. There are some exceptions where a valuation is chosen in an RBF deal like Earnest Capital’s SEAL.
    • Company – Alignment: In the short to medium term, many believe that there is a stronger alignment of interest between the founder and an RBF investor particularly around issues of growth and risk than with a VC investor. For a typical VC, they are seeking the rare huge growth companies and can be perceived as pushing individual founders to take on more risk in pursuing that growth. Since the upside is often capped for an RBF investor, they are less likely to push a founder to take on more growth risk if it comes with the risk of a wipeout.  Some argue that this alignment of interests is inherently limited in the timeframe as the RBF investor may be exiting the business in some predetermined number of years so may not be interested in truly long-term value creation.
    • Company – Cheaper Transaction: RBF deals tend to happen faster and are easier to document legally and therefore cost less than VC transactions.  I’ve seen them be easier than a typical bank loan, too, perhaps because of less regulation.
    • Company – Tax: For the company, if the RBF is treated as debt it can be favorable tax treatment to allow the company to deduct at least part of the payments as interest.
    • Company – Wider Industries: For founders, there is a wider set of industries where RBF has been active and makes sense than typical VC. You do not have to be in a “hot” industry that VCs are interested in and could be in the lower margin for example.
    • Company – Easy to Build Relationship: Many VCs emphasize the importance of warm-introductions in their sourcing strategies. Founders with fewer existing connections may find it easier to approach RBF investors as some position it as a more standard commercial transaction done at arms-length without the same courtship process.
    • Company – Relationship Can End: For most RBF deals, a company can exit the relationship with fixed pre-calculated buy-out that is more attainable than ending a VC relationship.
    • Investor – Fewer Write-Offs: RBF investors hope for fewer write-offs and I believe have experienced fewer complete wipeouts than VCs.
    • Investor – Underserved Market: Investors looking for less competition and the ability to reach underserved founders and markets, RBF offers that opportunity.  For example, the vast majority of Inc 5000 hasn’t taken VC investment and may be interested in RBF.
  • Trade-offs:
    • Company – Must be Growing Actual Revenue: The company must be expected to generate revenue soon and have enough margin or other financing to be able to pay the revenue-share back. Also want it to be growing enough to pay back the upfront investment.  Business plans that do not generate in the early years will not be suited for RBF.
    • Company – Lower Amounts of Capital Available: given the mathematical structure of the deal, there is a limit to the amount of upfront capital that makes sense.  It rarely exceeds $1 million. For companies that need more capital, they will want to find other sources. See Don’t go chasing unicorns.
    • Company – Impacts Cashflow: Compared to an equity investment into the company which is not required to be paid back until company sale (or similar), an RBF requires making room in cashflow for making payments now. Depending on the amount of margin and capital of the business plan, this can be a problem and may impact the ability to grow faster depending on circumstances.
    • Company –  Higher APR: Compared to bank debt, RBF is often has a higher cost of capital.  Although a company taking RBF may not qualify for traditional bank debt.
    • Company – Less Help: While some RBF do attempt to help portfolio companies like VCs although more are explicit that they don’t get as involved in companies and do not join boards.
    • Investor – Upside Can Be Limited: Since RBF deals have a capped total cash repayment amount and may not include warrants or an equity conversion or investment option, the upside can be fixed for an investor. Some investors argue that the RBF investor is not getting enough return for the inherent risk of the early-sage. The more equity-like participation that an RBF investor can obtain, can mitigate this to some extent. (See Why do VCs insist on only investing in high-risk, high-return companies?)
    • Investor – Possible Negative Selection Risk: Some investors argue that RBF will attract a higher proportion of founders who are focused on control and optionality to build a smaller business. They question if these are the founders that you want to work with or invest with to make money in a power-law investment landscape? There are legitimate set of questions on this topic combined with a dash of bias, a pinch of macho risk appetite, and a bunch of signaling happening when investors discuss this topic.
    • Investor – Tax:  For the RBF investor, if the transaction is treated as debt, you can owe taxes at higher rates and even on money not yet paid but imputed to be interest.  VC investments are structured to be taxed a lower long-term capital gains rates. BOMA’s Flexible Redemption Preferred Stock structure tries to structure the RBF transaction in a more tax-efficient manner.
    • Investor – Licensing: Some take the view that it is best to obtain various state lending licenses to do RBF at scale. (I am not familiar with the details.)
  • Examples: 
    • Lighter Capital
    • Decathlon Capital
    • BOMA
    • Novel Growth Partners
    • Indie.VC (includes the option to convert to equity)
    • Earnest Capital (their SEAL includes the option to convert to equity and focuses on net revenue after expenses rather than gross revenue to calculate the amount to pay to investors)
    • Clearbanc (slightly different model focused on financing ads and inventory)
  • Further Reading:
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