There comes a time in each company’s lifecycle when it needs financing, and a revenue-based loan may be the right solution for it. From startup funding to support during challenging times, a loan could answer various financial questions. While some businesses turn to traditional loan options, others discover alternative opportunities to get more support throughout the loan process.
Not being able to obtain a loan from a bank doesn’t mean your funding options are exhausted. A revenue-based loan is an excellent alternative for companies with less-than-perfect credit history, which requires quick and robust financing.
What is a Revenue-Based Loan?
Revenue-based financing is a way of raising capital for a business by paying a fixed percentage of the company’s revenue to the lender. In other words, the lender provides financing to your business in exchange for a part of its future revenue.
The company continues paying a percentage of its revenue until the pre-defined amount is fully repaid. The size of monthly payments varies based on how well the company is doing. For example, during slow months, the payment is lower. When revenues get stronger, payments increase.
Compared to other financing options like traditional debt and equity financing, revenue-based loans come with fewer risks and more convenience for the borrower.
How Do Revenue-Based Loans Work?
An investor provides an up-front or phased capital investment to the company. The parties agree to the amount which needs to be repaid. Generally, it’s a set multiple of the initial investment.
The payments are made every month. Their amount depends on the company’s monthly revenue. The better the business is doing, the faster the investment capital can be repaid, aligning the company’s and investor’s interests during the investment period.
For example:
- Borrowed amount — $50,000
- Amount to be repaid — $100,000
- Percentage of monthly revenue to be repaid — 10%
If your revenue this month is $40,000, you have to pay the investor $4,000. If next month, it increases to $100,000, you have to pay the investor $10,000. You continue doing it until $100,000 is repaid.
To appeal to a lender for revenue-based financing, the borrower should have:
- A specific annual revenue (the minimum varies from lender to lender and can be as small as $100,000 or as big as $10 million).
- Positive historical growth.
- Positive projective growth.
- Sufficient gross margins (to make sure monthly payments don’t put the business in a loss position).
- Limited current debt obligations.
- Cash flow positivity (or close to it).
While requirements vary from lender to lender, the basics are usually the same. However, it doesn’t mean that a startup can’t secure this type of financing. If a new company’s projective revenue appears reasonable, it’s possible to find an investor.
Revenue-Based Loan vs. Debt vs. Equity-Based Financing
For both large and small business funding, revenue-based financing is often a highly appealing alternative to traditional debt and equity financing.
Revenue-Based Financing vs. Traditional Debt Financing
While traditional debt financing options are common, they usually require:
- Collateral or a personal guarantee
- Good credit history
- Fixed payments
This can be an issue for companies that don’t have regular monthly revenue (e.g., contractors) or a solid credit history. At the same time, involving collateral and risking personal assets can be problematic.
With revenue-based financing, you can get a loan based on the history and potential of your business. Since monthly payments depend on your revenue, you don’t have to worry about being unable to pay the lender on time. Meanwhile, you don’t need to go through a time-consuming approval process or worry about bank lending limit restrictions.
The transaction costs for traditional loans are usually lower than for their revenue-based counterparts.
Revenue-Based Financing vs. Equity-Based Financing
These two financing types are similar because, in both cases, the funding is secured through investors or firms like VC (Venture Capitalists). However, with equity-based financing, you have to give up a share of your company or a seat on the board in exchange for funding. Essentially, you have to relinquish some control of your company to the investor.
With revenue-based financing, you hold on to your equity while taking advantage of the necessary funding. However, it can be easier to find investors for equity-based funding than the revenue-based structure.
Raising capital for companies doesn’t have to involve one type of financing. All three options can be used simultaneously.
Revenue-Based Financing and Revenue Bonds
The structure of revenue-based financing is somewhat similar to the structure of revenue bonds. A revenue bond is a municipal bond supported by the revenue from a particular public project.
Government agencies issue revenue bonds to finance a municipal project like a stadium or a highway. The revenue from the project is used to repay the invested amount (plus interest) to the investor.
Pros and Cons
Revenue-based financing can be an excellent option for a small to medium-sized company to secure funding without sacrificing part of its equity or pledging a part of its assets as collateral.
Here are the benefits and disadvantages of choosing this financing option.
Advantages of a Revenue-Based Loan
- The borrower is not required to provide collateral to investors. So you don’t risk losing control over the business and personal assets.
- You keep all your company’s equity and don’t relinquish any control (shares, board seats) to the investors.
- The amount you need to repay is fixed. Once the debt is repaid, no obligations to the lender remain.
- Since monthly payments are based on the percentage of your monthly revenue, you don’t have to worry about missing payment deadlines.
- Revenue-based financing doesn’t require a time-consuming approval process. The majority of investors can provide funding within a few weeks.
- This type of financing allows your business to thrive and grow, making other financing options easier to attain.
- With a long-term repayment structure, revenue-based financing gives you access to large sums of capital.
- You don’t need to have an excellent credit history or be in business for a long time to secure this type of financing.
Downsides of a Revenue-Based Loan
- Unlike equity-based financing, this loan structure requires regular monthly payments.
- Compared to other loan options, the cost of capital is extremely high. The amount of interest you accumulate can be twice the amount you borrow.
- While startups can secure such funding, you need substantial revenue and growth projections to appeal to investors in most cases.
- Not all companies have an easy time finding investors. Many lenders work with particular types of companies.
Overall, revenue-based financing isn’t suitable for all companies. Startups with low revenues and a short history may have trouble qualifying. However, the advantages of this funding option make it highly appealing to small and mid-size companies that have been in business for a while.
