The hardest part of starting a business can often be figuring out how to raise capital necessary to fund the business. Venture capital isn’t always easy to obtain and will require founders to give up equity. Meanwhile, banks are more stringent than ever in lending to small businesses. One alternative that has been gaining traction among startups and other small businesses as of late is another type of loan structure called revenue-based financing, where the future performance of the company determines how/if the loan is paid back.
Unlike a traditional loan with a fixed repayment term and interest rate, borrowers promise to pay a percentage of their future revenue. The debt is satisfied when the payments reach what is known as a repayment cap, a number set at the beginning of the loan that is usually equal to 1.5 to 2.5 times the principal amount of the loan.
For example, Company A borrows $100,000, with a repayment cap at 1.2x (or $120,000). With a revenue share of 3 percent, the company would pay 3 percent of its gross revenue each month until the total $120,000 has been paid. So, payments vary depending on how the company does. In this scenario, Company A would pay $30,000 toward the loan in a month where it has $1 million in revenue. If it has a slower month and generates $500,000 in revenue, it would pay $15,000. The benefit to the borrower is that its payment obligation varies, depending on its ability to pay. The lenders benefit because the rate of return the lender receives could end up being much higher than anticipated if the loan is paid off early because revenue exceeds projections.
Unless there is a drop dead date by which at least the principal amount must be repaid, the borrower risks the loan being categorized as equity, which would result in the payments not being deductible. So, we often put in a provision that states that on x date, the principal amount, minus any payments made to date, will be repaid.
The concept isn’t entirely new. It’s been used for years in places like the oil and gas industries and by drug companies to finance the high upfront costs of business. But in recent years these loans have generated interest from investment companies looking to expand into other areas, like technology.
For businesses, revenue-based financing can give access to capital without some of the downsides associated with more common types of financing. Lenders look at a company’s deposit history to determine eligibility and loan amount, so it doesn’t require perfect credit ratings or collateral to qualify. The performance-based repayments can help a company to manage seasonal swings or other fluctuations in cash flow. And the loan structure aligns the company’s interests with those of the investor, who sees higher and earlier repayments and the biggest upside when business is thriving.
That being said, revenue-based financing isn’t for everyone. The effective interest rate is often higher than a traditional bank loan. And if your business has low profit margins, revenue-based financing can hobble your cash flow even more. Typically, companies with at least $200,000 in annual revenue are best suited for this type of loan, as lenders typically target a 2-4 year repayment window.
Revenue-based financing is one more thing for small business owners to consider when looking at financing options. If your business is denied a bank loan or can’t find investors, it might be a viable alternative to raise the money necessary to grow your business.