Understanding Revenue-Based Financing

Revenue-based financing has become an increasingly popular funding option for startups and growth-stage companies over the past few years. But what exactly is revenue-based financing, and how does it work?

Essentially, investors provide upfront capital to a business in exchange for a percentage of its future revenue until the investor has recouped their investment plus a return. Repayment amounts flex up and down based on the performance of the business each month.

In many ways, revenue-based financing provides the growth capital and flexibility of venture capital funding without the loss of ownership and control.

Read on to learn more about how revenue-based financing works, its key benefits and drawbacks, ideal use cases, the types of companies it works best for, and how to determine if it’s the right funding solution for your business.

How Revenue-Based Financing Works

With revenue-based financing, investors provide an upfront sum of capital to a business. This capital acts as an investment, not a business loan, and the investors have no ownership stake in the business. Instead of taking equity or requiring collateral, the investors are paid back via an agreed upon percentage of future revenue until they have recouped their investment amount plus a previously defined return rate.

For example, if a business receives $1 million in capital from investors, with a 1.5x repayment rate, they would pay the investors a percentage of their monthly revenue until a total of $1.5 million has been repaid. This percentage typically ranges from 3-10% of monthly revenue, depending on repayment timeframe and risk associated with the business model.

The percentage remains fixed but, because it’s based on revenue, the dollar amount fluctuates month-to-month in line with the performance of the business. So if the business has a high-revenue month and brings in $200,000, the investor payment that month with a 5% revenue share would be $10,000. The next month, if revenue declines to $150,000, the investor payment would adjust to $7,500 accordingly.

This variable repayment structure helps align the investor and the business. When the business thrives and revenues increase, investor payments increase. But during slower periods, payments decrease to match the current realities of the business. This reduces the chance of defaulting on payments if revenues decline temporarily for seasonal businesses.

Key Benefits of Revenue-Based Financing

Non-Dilutive

Entrepreneurs can access growth capital without giving up any ownership stake in their company or diluting the equity stakes of founders and investors. With revenue-based financing, you maintain complete control and reap all future profits as the owner.

Fast Approval Process

Because revenue-based financing approval is based on revenue projections rather than credit scores or personal financial history, the application process is generally much faster than traditional bank loans. Investors can often fund within a few days of application.

Payments Scale Up and Down

The variable payment structure aligns investor risk with the realities of how the business is currently performing, increasing the chances of a positive outcome for both the investors and the entrepreneur.

Cheaper Than Equity

While revenue-based repayment percentages are higher than interest rates on debt financing, total repayment caps are usually between 1.2-2x the initial investment. Compare that to the much larger ownership stake typically handed over during equity financing rounds.

Drawbacks to Consider

Requires Consistent Revenue

Inconsistent revenue puts repayment risk on the entrepreneurs’ shoulders. Investors want to see predictable recurring revenue to ensure their investment will be repaid successfully.

Loan Amounts Limited By Revenue

Because revenue-based financing payments are a set percentage of revenue, the investment amount has to align with projected revenue to ensure sufficient cash flow for the business after payments.

Higher Cost Than Traditional Debt Financing

While cheaper than equity rounds in terms of company ownership, revenue-based financing is more expensive than conventional debt financing that typically has single-digit interest rates. However, traditional debt does require personal credit checks, collateral, and the ability to personally guarantee repayment.

Example Use Cases

Scaling Marketing and Sales

Many technology and consumer product businesses use revenue-based financing to quickly scale up advertising and hire additional sales staff to ramp revenue quickly when they see a product-market fit.

Improving Customer Retention

For subscription e-commerce or SaaS companies with recurring revenue models, revenue-based capital can fund initiatives to improve customer satisfaction, enhance products with additional features, and build out customer support teams to increase retention rates.

Buying Out Early Investors

As companies mature, founders often want to buy out early angels and investors to simplify their cap tables ahead of subsequent venture rounds. Revenue-based financing enables this without further diluting company ownership.

Bridging Equity Rounds

Companies raising traditional venture capital can use revenue-based financing to extend their runway between equity rounds. This helps them avoid emergency bridges or down rounds if revenue is delayed.

Should You Consider Revenue-Based Financing?

Evaluate Growth Capital Strategy

Think through your vision for future funding rounds and consider how revenue-based financing now could enable more favorable subsequent rounds.

Assess Revenue Predictability

Consistent recurring revenue that scales up gradually over time ensures a revenue-based financing agreement won’t strap your cash flow.

Analyze Potential ROI of Capital

Factor in what timeline you need to deploy the capital and achieve revenue growth that supports the investor payments.

Compare Financing Options

Run scenarios with revenue-based financing, equity rounds, traditional loans, vendor financing, etc to determine the best funding mix for your needs and risk tolerance.

Key Takeaways

Revenue-based financing brings non-dilutive venture scale growth capital to startups that’s cheaper than equity rounds with payments that flex with revenue rather than rigid loan terms that can choke cash flows if revenue slips. For the right businesses with recurring revenue streams, it can accelerate growth dramatically when deployed astutely between equity rounds.

Before committing to a revenue-based financing agreement, analyze financial projections and business viability thoroughly with trusted advisors to determine appropriate terms and repayment runway needed to scale successfully. Not all investors approach revenue-based financing deals equally, so due diligence to find the right partners is critical.