Using Revenue-Based Financing to Grow Your Business

What is revenue-based financing?

Revenue-based funding is a loan that a business agrees to pay back over time by promising a chunk of its future revenue to the financier until a fixed dollar amount is reached. 

• Fixed repayment target: Revenue-based financing is a loan with a fixed repayment target reached over several years.
• Fixed repayment amount: Generally, revenue-based funding comes with a repayment amount of 1.5 to 2.5 times the principal loan.
• Flexible repayment periods: With revenue-based funding, repayment periods are flexible; pay back the agreed-upon amount sooner if you can or later if you must.
• No loss of equity: With revenue-based funding, business owners don’t sell equity or relinquish control.
• More hands-off approach than private equity: Revenue-based financing firms work more closely with you than bank lenders but take a more hands-off approach than private equity investors.

Not every financing firm handles revenue-based financing precisely the same. “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 [back as] a percentage of their revenue until they’ve paid a set sum,” said BJ Lackland, co-founder and chief investment officer of IBI Spikes Fund. “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 outlines operations in its business plan. Still, it’s essential to recognize that the payments will be coming out of your business’s revenue stream and plan accordingly. 

Understanding your financial obligations means maintaining best practices (which you should be following anyway) like keeping adequate financial reserves and budgeting conservatively. [Related article: 7 Smart Budgeting Tips for Small Business Owners]

When do companies seek revenue-based financing options?

Revenue-based financing appeals to …  

• Growth-stage companies looking to hire additional salespeople.
• Companies 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.

Revenue-based financing is an alternative to debt financing and private equity financing. 

• Debt financing: While debt financing lets owners keep complete control of their businesses, they must sometimes put up personal assets as collateral – and even then, it’s usually for a comparatively paltry sum. 
• Private equity financing: With private equity financing, founders often balk at losing total control of their company. However, in exchange, they obtain their financing partner’s resources, network and experience.  

Revenue-based financing is the middle ground between these two options. While investors are unlikely to sit on the board or intervene in operations, they maintain a stake in the company’s success and growth 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. 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.”

Pros and cons of revenue-based financing

Like any funding option, revenue-based financing has benefits and drawbacks to consider. 

Pros

1. It is less expensive than alternatives. Revenue-based financing is less expensive than alternatives that involve equity. Other funding methods, such as angel investors and venture capitalists, require 10 to 20 times more in returns. Plus, those who provide revenue-based financing are invested in your success since the amount of the monthly payments they receive increases as your company succeeds.
2. You can maintain control. With revenue-based financing, you’ll maintain ownership and control of your company and keep your equity. Investors won’t gain power through board seats, etc., so you determine your business’s direction.
3. Monthly payments are flexible. Since monthly payments are based on revenue, slow months won’t hinder your ability to pay. Your cost is tied to your revenue and, with good planning, should remain affordable.
4. You don’t have to personally guarantee the loan. Financing options such as bank loans require you to guarantee a loan, putting your personal assets in jeopardy. Revenue-based financing doesn’t need that commitment.
5. You’ll raise funding more quickly. With revenue-based financing, you won’t have to make several pitches to attain the money you need. Most lenders will make their decisions and offer financing within a month.

Cons

1. You must produce revenue. A business must earn money to use this financing option, so it’s not suitable for startups without a regular income stream.
2. Less money is available than with other financing options. Some funding options, such as VCs, are known for heavily investing in a business. Revenue-based financing provides about three to four months of a business’s monthly recurring revenue.
3. Monthly payments are necessary. No matter what, you must make the monthly payment. Businesses short on cash should consider this factor.
4. This sector has minimal regulation. Because there’s little oversight of revenue-based financing, you must do careful research before entering any agreement, in order to avoid a predatory loan.

Revenue-based financing vs. bank loans 

Many businesses turn to banks for funding. However, sometimes revenue-based financing provides a better option. Let’s look at how one type of revenue-based financing, invoice factoring, compares to a bank loan.

Invoice factoring uses bills as collateral. You sell outstanding invoices to an investor for a lower amount than owed; for example, 80% of the total. Your business raises instant funds, and your customers pay the buyer instead of you for the goods sold.

Invoice factoring offers the following advantages:

• There is no debt or compounded interest. The average bank loan interest rate is between 2.5% to 7%, depending on the lender, loan type, collateral and other factors. Invoice factoring contains no debt or compounded interest. It also requires no payments since you’re selling financiers the bills upfront.
• Approval is fast. Approval comes more quickly with invoice factoring. A bank loan can take weeks or months, but if you have customers with good credit, the invoice factoring process can take just a few days.
• Your credit score is not considered. With invoice factoring, your business credit or personal credit doesn’t matter because your customers pay the investor.
• There is no capital limit. Bank loans will cap the cash available to you, but invoice factoring allows you to keep turning invoices into cash as long as you have creditworthy customers.

Bank loans require a borrower to pay a portion of the principal, along with interest, regularly until the total amount is paid. Bank loans also have some big benefits:

• You don’t need reliable customers. Invoice factoring relies on the availability of invoices from an appropriate customer base. If you need more money than your invoices can provide, a bank loan might be the better option.
• Banks provide many loan options. If you have good credit, you can often negotiate better interest rates and flexible payment schedules.
• Bank loans keep customer data private. With a bank loan, you don’t have to give another entity your customer data, as invoice factoring requires.

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 to draw debt service payments.
• Your company should have a relatively stable, established market.
• Your financials should be in order. Ensure you have an accurate summary of your debt, revenue, operating expenses and future projections.

Before committing your business to any form of financing, it’s essential to consider its long-term obligations. 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, helping you grow your business, hit your stride and reach the next level – all without risking personal assets or selling off part of your business.

Adam Uzialko contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.