Companies begin every day but don’t always have the funds to last. A lack of cash rings the death knell for many businesses. Fortunately, there are plenty of ways you can raise money to get your company off the ground. You might consider taking out a business loan. But you may also want to consider revenue-based financing.
What is Revenue-Based Financing?
Revenue-based financing is when companies raise capital by promising future revenue to get cash financing now. For startups looking to gain immediate financing, you can promise a percentage of revenue earned that will later go towards paying investors.
In order to get money, your company pays a future portion of earnings to investors. This percentage is agreed upon by the company and the investors. How much you repay might not be a set dollar amount, but instead, a percentage of revenue plus interest.
How Revenue-Based Financing Works
There are a few pieces that make up revenue-based financing:
- Principal amount. Like a regular loan, this is the amount you borrow from your lender.
- Rates. Sometimes this is referred to as “repayment caps.” This is the amount the borrower has to repay, usually written out as a multiple of the principal amount. For example, the repayment cap is 2x the principal amount.
- Repayment terms. This setup is different than regular personal loan repayment terms. Repayment is based on a percentage of revenue in the future. So when repayment starts is uncertain. Along with that, how much you repay varies month-to-month since revenue isn’t always the same every month.
Why Choose Revenue-Based Financing?
If you’re considering RBF (revenue-based financing), you might be able to take advantage of some of the perks, including:
- Retain ownership and control
- Quickly get the funding you need
- Pay based on monthly cash flow
Retain Ownership and Control
When companies look for venture capital funding, they tend to hand over some level of ownership to the VC, or Venture Capitalist. With revenue-based financing, you get to keep control of your company while still getting the money you need to run your business.
Quickly Get the Funding you Need
RBF is a somewhat fast transaction process. The only exchange is money, so as long as the repayment terms are agreed upon by both parties, it’s a quick deal.
Pay Based on Monthly Cash Flow
When you repay through RBF, you’re paying a percentage of your earnings. Since earnings aren’t necessarily the same dollar amount every month, what you repay won’t always be the same. When the time comes to start repaying through RBF, your percentage allows for a shift in payment amounts — not one dollar amount.
Disadvantages of Revenue-Based Financing
Even though RBF has its advantages, there are some not-so-great things to keep in mind, like:
- Capital cost is high
- No prepayment deals
Capital Cost Is High
Factor rates mean repayment can take longer and you’ll end up owing more money in the long run compared to other financing options. The interest you’ll pay is higher and it can take you much longer to repay the debt compared to other types of loans. The higher repayment cost and longer terms makes this type of financing expensive.
No Prepayment Deals
Some financing plans allow you to get a deal if you pay off your debt sooner than your final due date. Sometimes it’s a break in interest or a discounted payment. With revenue-based financing, those deals don’t exist. Even if you repay your debt sooner than the terms outlined, you don’t get to take advantage of a prepayment deal.
What Happens if my Revenues Decrease?
When your revenue goes down, it can be hard to repay your debt, even though revenue-based financing. The good news is that with RBF, even with a drop in revenue, your repayment amount will drop as well. Revenue-based financing is based on a percentage of revenue you earn, which can change from month-to-month. If your revenue takes a dip, the amount you owe will correlate to that.
If you’ve ever had an income-driven repayment plan on your student loans, it’s along those lines. IDR plans allow you to make payments based on your earnings. While those payments don’t fluctuate month-to-month, they are made to be based on what you can afford. RBF has the same sentiment — you’ll make payments based on your company’s revenue.
Alternatives to Revenue-Based Financing
While revenue-based might be a good plan for some companies, it’s not always the best plan for all companies. If you don’t think revenue-based financing is for you, try some alternatives.
Working capital loans
Working capital loans cover everyday operational costs to run your company. While there are a few different options, these loans are meant to help you pay for business expenses right now, not necessarily long-term investments.
This is where you trade outstanding invoices to a lender in return for working capital. Basically, you are selling your Accounts Receivables at a discount to access the capital before the invoice is due. The factor buys your old invoices and you get to use your money to run your business.
SBA loans are guaranteed by the U.S. Small Business Administration. You can use these types of loans for a variety of reasons, whether it’s long-term investments or short-term working capital to cover necessary operating expenses.
Merchant cash advance
If you don’t qualify for a traditional business loan, a merchant cash advance might work for you. This type of funding is like a personal cash advance, but for businesses based on the credit card transactions you process through your merchant account. You’ll get money by borrowing from your company’s future credit card sales or transactions. Because this can be a very expensive financing option, this should only be used if you don’t have many other funding options available, need cash quickly, and have a better-than-average handle on your business finances.
Equity crowdfunding is when you get money from an investor and in turn hand over a portion of your company’s equity. You’re not borrowing money that has to be repaid. Instead, you’re gaining funding through accredited investors who basically become business partners (minority shareholders). The crowd is more interested in the potential of your idea or your company than your credit profile, so a great idea with profit potential has a chance even if the business owner has less-than-perfect credit.
Like personal loans, you can get a small business loan from a bank when you need to borrow money. Because banks typically have very strict qualifying criteria, it can be difficult to qualify for a loan at the bank, depending on your company and how long you’ve been operating. Banks require strong business credit and a solid spending and earnings track record. Most businesses that apply for a bank loan are denied. But if you have the clout and need the cash, you might qualify.
If you’re looking for a way to get your company some cash and don’t want to commit to a traditional loan, revenue-based financing might be a good choice. It lets you repay your lender based on a percentage of your future earnings rather than a set dollar amount. But keep in mind that repayment terms can belong and interest rates are high. Although this might work for some companies, it’s not a good solution for everyone.
The good news is that there are plenty of other ways to get financing for your company, including small business loans and equity crowdfunding. Before you commit to one financing option, research all of them to see which one is right for you. You may find a mix of many choices might work. Not all companies operate the same way or have been around long enough to borrow money in a traditional bank loan. Thankfully, you have plenty of ways to borrow money for your business.