What does revenue-based financing mean?
Money is raised through revenue-based financing (RBF), in which investors give money to a business in exchange for a particular portion of its ongoing gross sales. Businesses like this option because it lets them get money without giving up ownership or using assets as collateral.
RBFs can have different structures. But usually, the business pays a set amount every month, a percentage of its total income. The time it takes to pay back the loan can be between three to five years, depending on how well the business does in sales.
For example, suppose a company makes a deal to receive $1 million in exchange for a part of its revenues. In that case, it might agree to pay 2.5% of its monthly revenue, up to a multiple of the original amount, to compensate the investors for the risk. The most you can pay back is usually a certain multiple of the loan’s value, usually between 1.35 and 3 times that amount.
From the point of view of an investor, RBF provides the chance for good results. However, it’s essential to remember that the repayment rate depends on how much money the business makes. The repayment rate will decrease if the company’s success does, too. With that in mind, it works best for businesses with high gross margins that make regular income, like SaaS companies.
Like words
- Getting money based on loyalty
- Loans based on income
- Funding based on income
- Getting money from sales
- Getting money from sales shares
- RBF
How does financing based on income work?
Revenue-based financing generally follows a simple (but unique) set of steps. In short, we can sum it up in these steps:
- Investment of money: A person or a group of people invests money in a business, but not as a loan or in exchange for business shares.
- Agreement on the amount of revenue: The business agrees to give the investor a set portion of its monthly gross sales in exchange for the money.
- How to repay the loan: The company repays the cash put in by making payments based on how much money it makes each month or year. The amount paid changes every month because it depends on how much the company makes that month.
- Cap or time on payments: Most of the time, the maximum amount that needs to be paid back is a multiple of the initial payment, such as 1.5x or 2x the initial amount. Another option is for the payments to keep going until a particular term is met, like a certain number of years.
Traditional bank loans vs. financing based on sales
Revenue-based financing is becoming more popular as an alternative to standard bank loans. Here are some crucial ways they are different:
- A good credit score is usually needed for traditional bank loans but not RBF.
- Most bank loans need security approval, but RBF loans don’t.
- Bank loans have set interest rates and payments, but RBF payments are based on a company’s income.
- Getting an RBF is usually easier than getting a bank loan, which can take weeks or months to approve.
- RBF usually has open terms, structures, and lengths to repay loans.
Many of these seem like good reasons to choose revenue-based funding over traditional bank loans, but there are also some bad things to consider.
RBF can cost more in the long run because it takes longer to pay back and has higher interest rates. It’s also harder to plan for because the company’s monthly income changes.
Different kinds of revenue-based loans
There are two main types of revenue-based financing: actual revenue-based financing and debt financing.
True Revenue-Based Financing
You can pay back this loan either regularly in a set amount or as a percentage of your cash flow. The repayments change based on how much money the company makes, which gives them freedom.
Financing for Receivables
There are two subtypes of this type:
Receivables factoring is selling individual bills to a person or business. If a particular contract offered under this deal falls through, it needs to be replaced with a different one.
Merchant Cash Advances (MCA): This is where the whole business is looked at, including its basic numbers like Annual Recurring Revenue (ARR), Burn, and Cash in the Bank. Businesses get a cash advance at a discount and pay it back in equal payments over some time, usually 6 to 18 months, with no interest.
What Revenue-Based Loans Are Like
By their very nature, revenue-based loans are different from other types of loans in a few critical ways:
They are paying back the principal. Revenue-based loans are different from traditional ones because they don’t have a set monthly capital amount to be paid back. They are instead paid a portion of the total amount of money the company made that month.
Rates of interest. Because of the chance of investing in new or small businesses, RBF loans usually have higher interest rates than regular loans.
No collateral is needed. Unlike bank loans, revenue-based loans don’t need collateral to get money. Instead, they use the future profits of the business as security.
Flexible ways to pay back the loan. The terms of RBF loans are usually open and can be changed depending on how well the business is doing and how much cash it has coming in and out.
- There is no loss of ownership. When a business owner gets RBF instead of equity capital, they don’t have to give up any ownership in the company.
What are the usual requirements for financing based on revenue?
Different lenders have different requirements for getting revenue-based funding, but here are some general ones that your business should be able to meet before it can get the money.
Making money and being profitable
Before putting money into something like this, investors want to ensure it will make money in the future. In most cases, you’ll need to show that you have a steady and regular way to make money.
This is why RBF works so well for companies that make money regularly. That’s also why they’re so popular in the SaaS space.
Minimum levels of income
A lot of RBF providers have minimum income standards. For example, some might need at least $100,000 in monthly recurring income (MRR) over the last six months.
Business Growth
RBF is popular among new businesses, but it’s unsuitable for starting companies. Businesses that have made steady money for at least six months are the ones that do it best. This rule helps investors determine how stable the business is and how likely it is to succeed in the long run.
Plane and Money Coming In
Companies should have a good amount of cash based on their present cash balance and monthly net burn rate. This shows how well the company can keep running and make payments in the short to medium term.
Location and Needs for Banking
Some RBF companies may only work with people who live in certain countries or have bank accounts in those countries. Most of the time, this is because it makes it easy for the provider to give out services and get paid.
Growth Expectations
As a general rule, RBF works best for growing companies. Some examples are AI, software development, and cloud computing. Because RBF is flexible and can grow with your business, these companies will most likely benefit from it.
Other Measures of Money
Lenders may also look at other financial factors, such as the Customer Acquisition Cost (CAC) payback period, the return on investment (ROI) from advertising and other channels for getting new customers, and the general liquidity of the business.
What are the pros and cons of revenue-based financing?
RBF Pros and Cons
As was already said, the best thing about RBF is that it is flexible. It is beneficial to get cash based only on the business’s success rather than having to put up collateral or deal with the strict rules of a bank loan.
This is a big mistake that SaaS owners make. This means that founders can keep a more significant share of the stock in their company, which is another benefit of RBF. Also, you won’t have to give up control of your business, which could hurt you in the long run.
Businesses can also use RBF as a safety net until they can get standard loans. In the meantime, RBF can be a good choice for new and small businesses still building their credit and income histories.
Problems with RBF
One big problem with RBF is that you can’t be sure when to make monthly payments. RBF repayment is based on a percentage of your income rather than a fixed monthly payment, like traditional loans. This can make budgeting and planning harder.
The higher interest rates with RBF can also make it an expensive choice for businesses over time. Some lenders may also add extra fees, which would make the total cost of borrowing even higher.
Lastly, the fact that buyers don’t lose ownership can be seen as a bad thing. They don’t have a direct say in decisions because they aren’t buying stock in the company. They also can’t gain from the sale or exit of the business. This only encourages them to focus on making the business more profitable and bringing in money, which could hurt long-term growth plans.
How Revenue-Based Financing Can Be Used
- This way of getting money is especially appealing to
- Companies in the growth stage that are hiring more people (primarily salespeople)
- Businesses that are releasing a new product or starting a GTM plan
- Businesses that are getting ready for a significant marketing effort or a big sales event
- People who own businesses and don’t want to give up their shares
- People who run a business but don’t want to promise a loan
- A business that isn’t big enough for venture capital but needs money to grow
- This business doesn’t have credit or a good financial history yet but has much growth potential.
- Businesses that have already gotten some money and are looking for ways to finance themselves other than through traditional loans
- Other options besides revenue-based financing
1. Financing with equity
Equity financing is a way for a business to get money by giving buyers shares of its stock in exchange for money. This is a popular choice for new businesses and companies with much growth because it doesn’t require returns or interest payments.
It’s a great alternative to traditional loans because it gives you money without putting you into debt. But there aren’t any regular payments, like with RBF.
However, you will give up some ownership of your company if you make this choice. Any investor who wants to buy stock in your business needs to know that you have a good track record, product, or idea.
2. Taking on debt
Companies take money from outside sources and promise to pay it back with interest. This is called debt financing. Businesses that have been around for a while have good credit, and always have cash coming in can make this choice.
Debt financing has lower interest rates than RBF, but the business owner has to put up security or give a personal guarantee. It also has set monthly payments, which makes it less flexible than RBF.
3. Fundraising through crowdfunding
To get money through crowdfunding, businesses can ask many people to give a small amount toward their funding goal. This choice has been around for a while—Kickstarter campaigns are how Oculus and thousands of other great companies started.
Through crowdfunding, businesses can reach more people and see if their product or idea will work in the market. However, a lot of marketing work is needed because the program needs to reach many people to be successful. The best businesses for it are those that are just starting and don’t have much money to show for their efforts.
4. Investing as an angel
Angel investors are wealthy people who put money into new businesses in exchange for company shares. They also offer advice and help, which can help grow businesses.
Equity can be anywhere from 5% to 25% of the company, but it changes from deal to deal. The best thing about angel investors is that they care deeply about the businesses and people behind them and want to help them.
Still, it can be hard to find the right angel investor, and the founder doesn’t always get more stock because they might end up building a helpful business that they need to dilute more in the future.
5. Capital for startups
It’s the most well-known type of support, but very few businesses get it. VC firms use money from wealthy people, businesses, and other investors to put money into early-stage companies with much room to grow.
You may have to give up a lot of stock (10 to 50%), but you can get a significant investment to help your business increase in exchange. VCs not only give you money, but they also give you access to people and experience that can help your business grow.
6. Financial Help and Grants
If your company is working on innovative projects, you might be qualified for grants or subsidies from the government. You don’t have to pay back these funds, and they can help you pay for things like marketing, hiring, and research and development.
You can probably get grant money for your business if it deals with healthcare, protecting the environment, or making new technologies that help people.
Grants are significant because they don’t need to be paid back or matched. But getting them can take a long time and be very tough.
7. Getting started
Of course, doing all the work yourself is one way to make money. This is impossible for some types of businesses, like medical devices, that must go through many tests, case studies, and approvals. One exception is if you’re making a niche SaaS product and have some cash saved. You might get by with intelligent choices and the money you have saved.
Bootstrapping isn’t always easy. You may have to work nights and weekends while you have another job, which can be slow and annoying. You’ll also have to think about lost opportunities. If you spent more, you could grow faster. If you choose this path, remember to save a lot of money for when you need it.
8. Notes for Converting
A convertible note is a type of debt that can be turned into stock at a later time, usually when the company gets more money. This type of financing helps early-stage companies secure capital before establishing a valuation and issuing equity.
These notes appeal to funders and founders because they give them options. Investors get the chance to gain equity without taking on the risk of a set valuation, and founders get money to grow their businesses without giving up any of their ownership right away.
9. How to Get Credit
Lines of credit are loans from a bank or other financial company that can be used repeatedly. They let businesses get money when needed instead of the whole amount at once. This can help you keep track of your cash flow and pay for short-term projects.
The bad thing about lines of credit is that they usually need security and have high-interest rates. This is very clear when you look at credit cards. If your business gets into credit card debt, you’ll probably have to pay it off for a long time.
Also, lines of credit might not give you enough money for big projects or long-term progress. This rests on your creditworthiness and the terms of your agreement with the lender.
10. Loans between Individuals
Crowdfunding and traditional loan financing are both parts of peer-to-peer lending. It means getting loans from people or groups instead of banks or other financial institutions.
Businesses that can’t get standard bank loans or have bad credit may be interested in peer-to-peer lending. The interest rates on these loans are usually very high (between 6% and 36%), but they can save businesses that need money quickly and don’t have many other choices.
