Starting a business is challenging in multiple ways.
Building anything, at the end of the day, is super stressful and often requires you to work under pressure.
But the biggest trouble you’ll find when thinking about your business is this: how do I raise the money to grow?
In this post, we’ll focus on one of the new popular ways to do so: revenue-based financing. We’ll cover what it is and its pros and cons.
What are the different ways of financing your startup?
When deciding to fund a startup, there are different options as to how you can finance it.
The most popular is, naturally, debt financing. This includes borrowing money from a lender or the bank.
Now, many people prefer to avoid asking for a loan from the bank because it requires you to give the bank personal guarantees due to the high-risk nature of startups.
You have to put on the line either a house, a car, or other personal assets.
There’s also equity financing, which involves a lower risk because you don’t have to regularly repay investors.
Instead, once the company is set, the investors will be partial owners of its profits and maybe even have the right to vote in company decisions.
A paradigmatic equity financing is angel investment, the financial capital was chosen by Shopify to get started.
Here, you’ll have to give the angel investor convertible debt or ownership equity.
This exchange can be quite difficult. The process of losing board seats and overall ownership dilution is a price not everyone is willing to pay.
Luckily, there’s a third way: revenue-based financing.
What is revenue-based financing?
Revenue-based financing, also known as royalty-based financing, is a type of financial capital that’s usually placed between bank loans and angel investments.
In revenue-based financing, investors give you capital in return for a fixed percentage of your revenue that you’ll give them until you’ve paid a set sum.
Generally, the repayment amount is about 1.5 times or 2.5 times the principal loan and investors expect it to be repaid within 1 to 5 years of the initial investment.
For example, if a company takes out an $800,000 loan, it might agree to pay back 6% of its revenue per month.
Although at first glance it might seem similar to debt financing, there’s one big difference: there are no fixed payments.
The Pros and Cons of Revenue-Based Financing
Revenue-based financing requires 2.5 times more in return, while equity-based financing models go up to 20 times more in return.
Equity is the most expensive source of capital if your startup is successful.
As mentioned before, monthly payments are a percentage of your revenue. This means you won’t be struggling to pay a fix number in your slow months.
You’ll give according to what you gain and won’t be burdened with a large payment you can’t afford.
Moreover, the time it will take you to pay the total amount is also flexible.
You’ll pay back the agreed-upon amount sooner if you can or later if you must.
You won’t have to give away any power over your company.
Investors won’t take board seats and you will be able to direct the company toward your personal vision.
Losing charge of your own business is a classic nightmare of the entrepreneur.
This point is also important in case you want to seek other financing options.
Oftentimes, founders decide to sell the company. In equity financing or venture capital, investors have the power to veto that decision.
In RBF, as long as you repay the loan, you can sell the company with no trouble.
No personal guarantees
You won’t have to personally guarantee the loan and put your personal assets in jeopardy.
That’s because there won’t be a bank asking you to put your house on the line.
Plus, sadly, sometimes banks have a liquidity crisis and you don’t want to get caught in the middle of that.
Little Spoon is a company that could have had it really bad if they hadn’t pulled the money from Silicon Valley Bank (aka “the bank of startups”) before the collapse.
Revenue-based financing doesn’t require you to achieve hyper-growth.
That’s why investors aren’t that picky and you won’t have to spend months or years making several pitches to attain the money you want.
Most lenders will make their decisions and offer financing within a month or even days!
Not having to present a pitch deck also makes the whole process much simpler. In fact, there’s often very little paperwork involved.
Unlike venture capital, in revenue-based financing, you and your investors benefit from the company’s growth and want to see it thrive. If revenue falls, both suffer, too.
This alignment reassures you that your investors and you are a team working for the same goal and that they care about your company.
Moreover, as the company grows, investors may choose to provide follow-on funds, providing entrepreneurs access to more capital over time.
Works well with other funding sources
Revenue-based financing helps early-stage startups build traction, which makes other forms of funding more accessible and less costly.
Since it’s revenue-based, if you are pre-revenue or don’t have a regular income stream, you won’t be a fit for this financial option.
A revenue-based investor uses metrics and growth projections to determine eligibility for a loan.
Usually, the metrics they will see are the Monthly Recurring Revenue (MRR) and the Annual Recurring Revenue (ARR).
You can calculate them yourself or use analytics software such as Baremetrics to help you understand your performance.
Less money available
Venture capital is known for giving companies an enormous amount of cash, even if they don’t have a regular income stream.
In revenue-based financing, on the contrary, investors’ capital is worth 4 months of a company’s MRR maximum or a third of the company’s annual recurring revenue.
You must pay monthly
You should be careful of the amount of financing you take, since monthly payments are required. This is not the case in equity funding.
On the other hand, if the repayments drag out for a long period of time, a fixed-term bank loan becomes more economical.
Currently, there are no regulations on revenue-based financing. That’s the flip side of little paperwork.
So before signing any agreements, it’s highly recommended a thorough study on your potential investor to avoid taking out a predatory loan.
Unscrupulous lenders might ask for extremely high-interest rates or excessive fees.
Who can benefit from revenue-based financing?
Although in this post we focused on RVF for startups, the truth is this financing option isn’t limited to them.
In fact, already established companies might also find RVF attractive if they are releasing a new product or seeking to keep growing in any way.
These are some industries that will particularly benefit from it:
E-commerce businesses will attract the interest of lenders and be able to quickly pay the loan.
As they sell online, lenders can easily access data from their business accounting and marketing accounts and forecast their performance.
With this funding type, the business will also quickly invest in marketing or inventory to meet demand.
Companies with seasonal performance
If your company highly depends on festivities or does better at certain times of the year, the performance-based nature of RBF will bring you calm.
You can stock up on inventory and shore up ad spending for the peak season, then quickly pay off their loan with the revenue they make.
Subscription businesses have a high amount of predictability.
As they have a clear idea of how much to expect each month, they can seek RBF and be sure they’ll handle finance just right.
Entrepreneurs’ biggest question is how to raise money for their startups. Revenue-based financing has become a quite popular answer to that recently.
It’s certainly not for everyone since, like its name spoils, pre-revenue startups are not a fit.
To pursue revenue-based financing, your company should have an established revenue stream and have its financials in order.
But if you do, the benefits are huge. You don’t dilute equity and can keep growing without worrying about whether you’ll meet the cost of a fixed loan