Securing financing for your startup or growth-stage business isn't always easy. Sometimes, banks can be hesitant to lend or will demand a personal guarantee for any loans. Venture capitalists (VCs) or angel investors, when you can even find them, are always looking for big returns and a hefty slice of equity. For the entrepreneur, this creates a difficult situation. How can you continue to invest in your business without finding sufficient capital?
For businesses searching for a happy-medium between the world of conventional bank loans and the high stakes game of private equity investments, revenue-based financing might fill the void. But what is revenue-based financing? In short, it's a loan that a business agrees to pay back over time by promising a chunk of their future revenues to the financier until a fixed dollar amount is reached.
What is revenue-based financing?
- A loan with a fixed repayment target that is reached over a period of several years.
- Generally comes with a repayment amount of 1.5 to 2.5 times the principal loan.
- Repayment periods are flexible; pay back the agreed-upon amount sooner if you can, or later if you must.
- Business owners do not sell equity or relinquish control when using revenue-based financing.
- Revenue-based financing firms work more closely with you than bank lenders, but take a more hands-off approach than private equity investors.
"Everyone does it a little bit differently, but the way we use revenue-based financing is to provide a sum of money ... which the company agrees to pay a percentage of their revenue until they've paid a set sum," BJ Lackland, CEO of Lighter Capital, told Business News Daily. "The key to the whole thing is if a company grows faster than expected, they pay us in a shorter period of time, which means our ROI goes up. Or it may take longer than we expect, meaning ROI goes down."
Generally, revenue-based financing comes with a repayment amount of about 1.5 times to 2.5 times the principal loan. The fixed dollar target can be helpful when a small business is planning out operations, but it's important to recognize the payments will be coming out of your business's revenue stream and to plan accordingly. That means maintaining best practices (which you should be following anyway) like keeping adequate financial reserves on hand and budgeting conservatively. [See Related Story: Beyond the Bank Loan: 6 Alternative Financing Methods for Startups]
When do companies usually seek revenue-based financing options?
- Growth stage companies looking to hire additional salespeople
- When a company is in the midst of launching a new product
- Companies on the cusp of a large-scale marketing campaign
- A company with an established market, but not one large enough for VCs
- Owners who don’t want to personally guarantee a loan OR sell equity
While debt financing allows owners to keep complete control, sometimes they must put up their personal assets as collateral, and even then it's usually for a comparatively paltry sum. When it comes to private equity, on the other hand, founders often balk at the loss of total control of their company, but in exchange obtain the resources, network and experience of their financing partner. Revenue-based financing, again, is the middle ground; while companies like Lighter Capital are unlikely to sit on the board or really intervene in operations, they do maintain a stake in the success and growth of the company in a way banks do not.
"Banks are mostly concerned about getting their money back and making a small return," Lackland said. "VCs and angels are just looking for huge upsides. They make their money on 10x returns; they're constantly hunting for a home run hit. We're in the middle; we like to call ourselves VC lite. We're there to help and talk, but we don't look over your shoulder."
Related Article: Difference Between Debt and Equity Financing
Is revenue-based financing right for you?
Revenue-based financing isn't the best choice for every company. Before you pursue it, consider the following:
- Your company should have an established revenue stream from which to draw debt service payments.
- Your company should have an established market that is relatively stable.
- Your financials should be in order. Make sure you have a summary of your debt, revenues, operating expenses, and future projections, and be sure it’s all generally accurate.
Before committing your business to any form of financing, it’s important to consider the long-term obligations you’ll be signing up for. A loan is a loan, and that means repayment is a must. When it comes to revenue-based financing, it might seem like there are fewer strings attached to the money, but treating it flippantly is a recipe for disaster.
“It’s incredibly flexible, but it’s still a loan,” Lackland said. “You need to be ready to handle those obligations. We try to make it really light on entrepreneurs, but we’re a capital provider and we have an obligation to our investors.”
Still, revenue-based financing is another tool in the entrepreneur’s toolbox and it can help growth stage companies hit their stride and reach the next level; all without risking personal assets or selling off part of the business.