Neil Patel

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Entrepreneurs exploring suitable sources of capital and funding should take the time to understand how revenue-based financing empowers startups. Revenue-based financing (RBF) has several advantages over traditional capital sources, though you’ll want to evaluate suitability for your needs.

This capital source is quickly catching the interest of small business owners and founders looking to start a new venture. Research suggests that the revenue-based financing worldwide market will grow at a CAGR of 62.8% between 2020 and 2028. The industry is expected to touch $42.3 billion in 2028 from $901 million in 2019, which is an exponential growth.

Are you looking for capital investment for your startup but without the need to cede equity or pay high interest? RBF could be exactly what you need since you’ll only commit to paying a percentage of the company’s gross revenues. Read ahead to understand how revenue-based financing works.

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    Understanding Revenue-Based Financing in Detail

    Also referred to as royalty-based financing, revenue-based financing is where founders pay investors a part of the revenues. The payments continue until a predetermined amount is paid back.

    Payments are made every month, quarter, or semester, as agreed in the terms and conditions. Usually, the payable sum is a specific multiple of the principal amount and ranges from three to five times the investment.

    Founders can use the money for any purpose, like building the infrastructure for the fledgling venture or scaling the company. When you have limited resources but want to retain complete control over the company’s decision-making, RBF could be the ideal option.

    This form of capital is especially suitable for IP-backed startups who would prefer to restrict access to the startup’s IA. Or intangible assets. Venture capitalists also prefer this model when backing SaaS ventures.

    Investment repayments are dependent on the company’s performance and the income it generates every month. If you have limited sales during one month, the repayments will be lower. But if you have higher sales the next month, the royalty payments will rise accordingly.

    Investors considering your pitch will evaluate the company’s historical revenue data, business model, and performance before offering funding. They also factor in its future growth prospects and the overall market volatility.

    More entrepreneurs running small and mid-sized companies now prefer RBF to traditional options like bank loans, venture debts, and others. Thanks to the prospect of getting non-dilutive funding. That’s how revenue-based financing empowers startups.

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    Calculating Repayment Caps

    The initial funding amount dictates the repayment cap. Lenders calculate the repayment cap rate or factor rate and use this number instead of a rate of interest. That’s how they arrive at the repayment amount.

    Founders determine the total repayment amount by multiplying the initial funding amount by the repayment cap. For instance, if the initial funding amount is $200,000 and the repayment cap is fixed at 1.1. Then, the total payable amount is $200,000 x 1.1 = $220,000.

    The lender also works out the fixed percentage of the revenue you’ll repay each month. Typically, this figure is 1% to 3%, but can be higher depending on the loan’s terms and conditions. The payment each month will vary according to the revenues the company generates.

    When estimating the percentage, lenders take into account the amount of revenue the startup is likely to earn each month. They’ll also factor in the total expenses the startup will incur. Payments need not be made each month but according to the terms, both parties agree to. For instance, repayments can be quarterly or every six months.

    The loan duration is not always pre-determined, but that also depends on the particular lender. Some investors may offer revenue-based financing payable over three to five years.

    How Revenue-Based Financing Compares to Traditional Funding

    Acquiring traditional funding comes with several challenges. Application procedures are typically complex and time-consuming, and approvals can take time. You’ll structure applications according to the investors you’re targeting with frequent email back and forths.

    However, applying for RBF is quickly done by filling out applications online. Once your loan approval comes in, you can expect to receive the funding within 3 days. Since you’re offering revenue-driven collateral, you need not provide information about the startup’s credit history.

    Traditional capital sources require you to provide not just credit history but they may also require detailed information. You’ll provide data like the company’s business model, financials, core team, product-market fit, performance history, and market analysis reports.

    Applying to venture capitalists, angel investors, incubators, and accelerators typically starts with creating a compelling pitch deck and delivering a pitch. That’s a process that can take months to execute. Not so with revenue-based financing.

    Revenue-based financing has several advantages over traditional sources of funding. Here’s a quick look at how they compare.

    Equity Financing vs. Revenue-based Financing

    Revenue-based financing is distinct from equity financing since investors don’t acquire any ownership in the business. On the flip side, venture capitalists may offer larger capital amounts without the need for assurance of repayments. Though, you will have to give up board seats and voting rights in exchange for the capital.

    These investors support a diverse portfolio of business verticals and industries, which disperses their risk. This factor makes it possible for them to support high-risk startups.

    Founders needing mentoring, advice, access to investor networks, and other perks of venture capital might want to go for it. With RBF, you only get capital that has to be repaid.

    Bank Loans vs. Revenue-Based Funding

    Getting bank loans requires founders to follow their credit structures. You’ll repay the principal along with a fixed interest amount at regular intervals. While you can get high amounts of funding, you’ll also have to provide collateral.

    Most importantly, founders must repay the loan on a predetermined schedule without any flexibility. Banks may also levy penalties on late payments.

    However, similar to revenue-based funding, you need not cede equity, control, or board seats. You also get flexibility with repaying the loan, which is how revenue-based financing empowers startups and their founders.

    Debt Financing vs. Revenue-Based Capital

    Debt financing and revenue-based capital are similar in many ways. To begin with, both options carry affordable interest rates without the need to give up equity or board seats. However, debt financing lenders require you to make fixed amount payments at regular intervals.

    You may also have to pay interest on the outstanding loan amount. And offer some collateral to secure the loan.

    On the upside, debt financing helps you build robust credit scores that can prove to be an advantage later on. Further, you can write off the interest payments as a business expense in your tax return and claim deductions.

    Like with RBC, you’ll use debt financing to purchase inventory and equipment, hire new talent, and invest in aggressive advertising. Founders may also set up additional work premises like a second store and scale operations.

    Accounts Receivable-Based Financing vs. Revenue-Based Financing

    With account-receivables financing, the company takes loans against outstanding invoices or the money it expects to collect from customers. You’ll acquire loans that are equivalent to a reduced value of the pledged receivables.

    The startup’s balance sheet will show the accounts receivable as an asset with an invoice payment paid within a year. You’ll borrow against this asset, using it as collateral and transforming it into liquidity to invest in the company’s operations.

    Any loans taken as accounts-receivable financing are around 90% to 100% of the asset’s value.

    Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

    Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

     

    How Revenue-Based Financing Empowers Startups

    Revenue-based funding does come with several perks. However, you should be fully aware of the downsides before signing up. Weigh your pros and cons carefully before you accept the funding.

    With RBF, you can choose the repayment terms and conditions and work them according to the company’s performance. This factor gives you the flexibility to repay the loan as and when the startup rakes in good revenues.

    Since you’re providing collateral, the due diligence process and credit checks are less complex. This means that you can access the funding almost instantly. On the flip side, this financing option is not suitable for startups that have yet to generate regular revenues.

    Further, if you need larger amounts of capital to scale the company quickly, you’ll have to approach other funding sources. Although the revenue-based financing sector is growing rapidly, the funding available is nowhere near the scope offered by traditional sources.

    While founders can leverage the facility of making repayments per company performance, this factor can also be a downside. Future investors examining the startup’s financials may not view the loan favorably.

    Considering that royalty payments take away a portion of the company’s revenues, that could affect the net profits. Market conditions can also influence revenues and can influence the company’s growth prospects.

    Founders should factor in the possibility of interest rates increasing and inflation eating into the revenues. These conditions can, in turn, affect the repayments and loan durations. The most crucial differentiating factor between RBF and traditional funding options is the availability of other perks.

    Qualifying for venture capital, bank loans, angel investment, and incubator and accelerator programs adds to the company’s credibility. Future funding rounds and strategic partnerships with vendors and buyers will be a lot more streamlined.

    Customers may also rely on companies that have reputable backers.

    What Kind of Startups Should Consider Revenue-Based Funding?

    As discussed, founders should consider the perks and downsides carefully before opting for RBF. Here are some of the typical conditions when you can consider RBF as an appropriate source.

    When Looking to Scale the Company Quickly Without Dilution

    At some time, your startup could be poised on its growth trajectory to scale quickly. You may have more than adequate cash flows to meet the company’s operational expenses. However, they may not be sufficient for investing in aggressive advertising and marketing approaches.

    The startup may need additional funds to cover overheads like logistics, shipping, digital marketing initiatives, hiring talent, and customer service.

    Since the company is performing well, you may not want to give up control over the decision-making. In this scenario, you can consider pitching for funding to revenue-driven investors who are open to accepting revenue payments.

    You’ll use the funding to grow the company without having to give up equity and the possibility of dilution.

    Are you ready for more information about the different sources of funding for your business? Check out this video I have created explaining in detail the various options you can consider.

    When Working to Fill Large Orders

    Startups with the ideal product-market fit that has captured a robust customer base may want to ramp up production quickly. To match the burgeoning demand for your products, you may need funds to purchase inventory and invest in efficient production.

    Tapping into royalty-based financing can help you with that extra runway so you can deploy orders on schedule. The extra funding will result in an excellent customer experience and satisfaction.

    You can always pay off the loan from the steady revenue streams you generate. That’s one of the ways how revenue-based financing empowers startups.

    When Funding Rounds Are Insufficient

    Startups estimating their asking amount incorrectly during funding rounds is a real possibility. You may realize that you allocated the money you raised toward strategic operations. However, you’re still short of funding for other needs.

    Not only is the startup not ready for a new funding round and further dilution, but you need money to manage operations. A great option to fill the gap is revenue-based financing. You can use the funds to keep the company running until it’s ready for fundraising again.

    By the time the company starts a new fundraising initiative, the loan will have been paid off.

    Is Revenue-Based Financing A Viable Strategy?

    Revenue or royalty-based funding is an excellent source of short-term capital for a startup. The money can cover its immediate needs. And, since the loan durations are short, they can fill the gap between funding rounds.

    Before you secure this funding option, do the research into how revenue-based financing empowers startups. Weigh your options carefully and pitch for the most favorable terms and conditions. Don’t hesitate to negotiate for economical repayment caps and loan terms.

    You may find interesting as well our free library of business templates. There you will find every single template you will need when building and scaling your business completely for free. See it here.

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    Neil Patel

    I hope you enjoy reading this blog post.

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