If your business has significant recurring revenues, revenue-based financing may provide growth capital without requiring you to give up equity. Learn whether it’s right for your business.
What Is Revenue-Based Financing?
Revenue-based financing (RBF), also known as revenue-based investing or revenue-share financing, is a form of financing that allows small businesses to get financing and pay it back from future revenues. Payments are based on a weekly or monthly percentage of revenues, until the financing is repaid along with the fee, which is usually in the range of three to seven times the initial investment.
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How Revenue-Based Financing Works
Revenue-based financing or revenue-based investing typically describes an arrangement where investors provide financing to businesses with strong ongoing revenues. Often the companies making these loans specialize in certain types of high-growth industries such as Software as a Service companies. It can be an alternative to traditional venture capital or angel investment structures that require the business to give up some equity in exchange for funding.
Unlike a traditional small business loan that requires fixed monthly payments (or sometimes weekly payments), revenue-based financing offers more flexible repayment terms. The investors or company providing the funding or financing will get paid a percentage of future revenues until the total agreed upon repayment is reached. When revenues are lower, payments will be lower, and when they increase, payments increase.
There will be a repayment cap that will determine the total cost of financing. It can be as low as 1.35% of the original investment amount, or as high as 10%, though there is no legal limit that caps how much these companies can charge.
Pros and Cons of Revenue-Based Financing
- More flexible approval criteria than loans
- Owner may avoid a personal guarantee
- Payments fluctuate with revenues
- No dilution of equity
- Fast funding
- Cost of capital higher than traditional commercial loans
- Requires significant recurring revenues
- Not available to all industries
Revenue-based financing is typically more flexible than standard small business loans which require at least a couple of years in business, good credit scores and strong revenues. The entrepreneur may also be able to avoid a personal guarantee.
This type of funding does not require the small business to give up equity in the business, but it’s likely to be more expensive than a traditional small business loan such as a commercial bank loan or even an SBA guaranteed loan.
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Revenue-Based Financing vs. Debt and Equity-Based Financing
Debt financing is another term to describe a business loan. With this type of financing, entrepreneurs borrow money and pay it back over time with interest, typically by making monthly payments. The cost of financing may be described using an interest rate, fee, or some other terminology. In most cases, small business lenders are not required to disclose an annual percentage rate (APR).
Some small business loans carry very low interest rates. Traditional bank loans and SBA loans guaranteed by the Small Business Administration often carry the lowest interest rates, though micro loans and some online loans are also relatively inexpensive.
The advantage of a small business loan over RBF is typically the cost. Borrowers who qualify for a small business loan at a low interest rate will likely find that option cheaper than a revenue-based financing arrangement.
On the other hand, small business loans require regular payments that can be difficult to make, especially for a business that is new and growing, or experiencing fluctuations in revenues.
Equity financing allows businesses to get funding from investors, whether those are private equity investors, angel investors, or venture capitalists — and this is especially common with startups. There is even a type of crowdfunding that allows businesses to raise money from large numbers of investors.
The advantage of equity investments is that they can be structured without payments. Investors cash out when there is a liquidation event (such as going public or getting acquired). However the advantage of RBF over this type of funding is that it does not require giving up equity in the business. So, the business owner doesn’t give up control of the business.
Rates and Terms of Revenue-Based Financing
Revenue-based financing can be structured in various ways but the defining feature is that payments will be tied to gross revenues. When revenue decreases, so do payments. Higher revenues allow the business to repay the financing faster but that won’t likely reduce the total amount owed.
Here is an example of how this financing may be structured:
Lighter Capital, a leader in this type of financing, provides loan amounts up to $3 million for tech companies with monthly recurring revenue (MRR) of at least $15,000 over the last three months and at least five clients receiving products or services. Borrowers may qualify for a loan for up to 33% of annualized revenue run-rate. (To illustrate, the example from their website states that a business on track for $1 million in sales this year can receive a loan of about $330,000.) Payments are based on a fixed percentage of income ranging from 2% to 8% but no more than 10%.
*All information about Lighter Capital has been collected independently by Nav. These loans are not currently available through Nav.
How to Qualify for Revenue-Based Financing
True revenue-based funding has very specific requirements. The first and most important requirement for this type of financing is that the business has sufficient recurring revenues. As mentioned before, it’s typical with this type of financing that firms (or investors) will be looking for businesses in certain industries such as technology companies with a track record of generating recurring revenue and strong potential for growth.
As part of the application process, the business must be able to confirm the source of revenues and may also need to document how it will use new funding to grow the business. Minimum recurring revenue requirements of at least $10,000 to $20,000 or more per month would not be unusual. There may be annual revenue requirements as well.
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How to Get Revenue-Based Financing
Ideally when you’re looking for small business, you’ll want to shop around for financing options that best fit your business needs and for which you qualify. Since RBF is available through specialized financing companies, you may have very limited options. You may find potential investors from the investment community, or perhaps from a trade association or networking with other entrepreneurs in your industry.
If you don’t fit the rather narrow criteria for RBF, you may want to look at other types of financing based on revenues. Businesses with solid monthly revenues may qualify for a merchant cash advance or business cash advance, for example. Both of these products offer advances against future revenues and will rely largely on recent revenues (often the last six to 12 months) to make an underwriting decision. MCAs and BCAs are widely available to many types of businesses, as long as they have sufficient revenues. Credit score requirements are typically very low.
Another type of financing that looks at revenues is accounts receivable financing or invoice financing (or factoring). With that type of financing, the business is pledging income from sales that have already occurred, but for which it has not yet been paid.
Understanding which type of financing is right for your business can be confusing. One option is to work with a small business financing marketplace that can match your business to financing based on your qualifications.
FAQs About Revenue-Based Loans
What are revenue-based loans?
Revenue-based financing is a way for small businesses to secure funding using their future revenues. It’s an alternative to using investors or venture capital firms. With a revenue-based loan, our business will pay back a percentage of your weekly or monthly revenues until you have paid off the funding in full, including the fee from the lender. The total cost is usually between three and seven times what you initially borrowed.
Which is better, equity or debt financing?
Whether or not your business would be better suited for equity financing or debt financing depends on your situation and goals. Startups typically rely on equity financing, which means you find an investor or venture capital firm to invest in your business. This type of financing requires you to give up a portion of the control of your company, so anyone who wants to retain total control may find that debt financing works better for them. Debt financing means taking on debt, like a small business loan, and paying it back over an agreed-upon term. Unlike equity financing, you’ll have to make monthly payments, and some small businesses may have a hard time affording them. Weigh all the pros and cons between equity and debt financing before deciding which one would fit your business goals best. Also, make sure that your business credit scores are high enough to qualify for financing.
What comes under indirect expenses?
Indirect costs are business expenses that aren’t linked to a project or a product your business creates. These expenses are what you owe to run your business day-to-day, like rent, office computers, marketing, and utilities. Indirect costs can be fixed, like rent that doesn’t change month-to-month, or variable, like electricity that will vary monthly based on your usage.
What does debt financing mean?
Debt financing is taking on debt, like a small business loan, to pay for business expenses. It requires you to borrow an amount of money that you pay back over an agreed-upon time period called a term. Borrowers make a monthly payment of the principal plus interest on the amount borrowed. Many small business loans can offer lower interest rates than other forms of small business funding, but the interest rate you get depends on your qualifications.
What is the best way to finance inventory?
If you’re looking to pay to expand your inventory through funding, there are many small business financing options you may be able to access. One option is an inventory line of credit that gives you a credit limit, or a certain amount you can borrow at one time. You can pull from the line of credit as needed and only pay interest on what you use. Other kinds of inventory financing include short-term loans, inventory factoring, and merchant cash advances. Business credit cards can also add to your business’s cash flow to increase inventory.
What is a floating lien?
A floating lien is a way for a business to put down collateral on a loan. Collateral backs up the loan in case a business can’t pay it off, so the lender can seize the collateral if regular payments stop. For example, a small business like a retailer can use inventory as collateral to obtain a small business loan. The inventory your business has in stock might shift (or float) — so it might go from warm sweaters in the winter to graphic T-shirts in the summer — and so the value of the inventory also changes. That’s why it’s considered a floating lien.
This article was originally written on December 17, 2021 and updated on February 15, 2023.
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