Revenue-based financing, also known as royalty-based financing, is a type of capital-raising method in which investors agree to provide capital to a company in exchange for a certain percentage of the company’s ongoing total gross revenues. It is an alternative investment model to more conventional equity-based investments, such as venture capital and angel investing, as well as debt financing.
Revenue-based financing is an attractive method of raising capital for companies. A company may successfully raise the required capital without sacrificing part of its equity or pledging a part of its assets as collateral. Furthermore, relative to debt and equity financing, revenue-based financing is a much easier process that requires less documentation.
Revenue-based Financing vs. Debt and Equity-based Financing
Revenue-based financing seems similar to debt financing because investors are entitled to regular repayments of their initially invested capital. However, revenue-based funding does not involve interest payments. Instead, the repayments are calculated using a particular multiple that results in returns that are higher than the initial investment. Also, in revenue-based financing, a company is not required to provide collateral to investors.
Unlike equity-based investment models, there is no transfer of an ownership stake in a company to investors. However, it is common that some equity warrants may be issued to investors. Finally, in such an investment model, a company is not required to provide investors with seats on the board of directors.
How Does Revenue-based Financing Work?
Imagine you are the CEO of a small SaaS company. You believe that further growth of the company may be ensured by an expansion that requires the injection of an additional $1 million in capital. However, you are not able to obtain a loan from banks, and shareholders are not willing to dilute their stake in the company by attracting new investors using equity-based financing. Thus, you decide to raise the capital using revenue-based financing.
Your company arranges a deal with ABC Capital, which specializes in revenue-based financing. The deal states that ABC Capital will provide the required $1 million in exchange for a portion of your revenues. Your company will be required to make monthly installment payments equal to 2.5% of your overall revenue. Additionally, you need to pay 1.5x multiple of the original amount to compensate the investors for the risk.
From an investor’s perspective, revenue-based financing provides an opportunity to earn lucrative returns. Nevertheless, an investor should be aware of the risks associated with the financing model because the repayment rate has a direct relationship with revenues. If the company’s revenues experience a significant decline, the repayment rate will drop proportionally.
In addition, the revenue-based financing model is not suitable for every company. The model works only with companies that are generating sufficient revenues. In addition, a company that aims to resort to revenue-based financing must have strong gross margins to ensure their ability to repay the investment. Generally, revenue-based financing works best with SaaS companies.