If you're an entrepreneur who has been tinkering with the idea of getting your business funded soon, you probably think your only options are either:
- Approaching a bank
- Chasing down a venture capital fund
- Scrolling through AngelList to find angel investors interested enough to fund your business
Early businesses usually rely on two sources of funds to fuel their growth:
Debt & Equity Financing
Unfortunately it is difficult for startups to secure funding from banks due to their high perceived risk. Equity financing via Angels and Venture Capitalists is also far from easy. Expect to spend anywhere from 6 months chasing down investors for capital, only to give up ownership and control if they see enough potential (aka money down the road for them) to make a deal. Shouldn't you be spending your time on more important things like building your business?
The new kid on the block? Revenue-based financing.
In the traditional form of equity financing, investors expect a “10x” return on their investment, meaning they expect that the company will exit at one point for a sufficient amount that will earn them at least 10 times their money back.
That’s a $5 million return for a $500,000 investment.
In comparison, revenue-based financing is provided by investors that see potential in a business, just like an Angel or Venture Capitalists might. However, the investor does not obtain ownership and offers the business a loan that gets repaid by taking a portion of the business’s “top-line” revenue.
In a way, revenue-based financing still uses equity, but the business buys the equity back using a small percentage of revenues, typically between 1–10%, returning 1.5 to 3x the amount invested over 2–5 years. An investor’s expected annual return — at least at Seedlify — is 15–30%.
That’s $750,000-$1.5 million for a $500,000 investment.
Revenue-based financing is a loan, but there are no fixed payments, no set time period for repayment, and no interest rate. Every month, the business pays the investor a fixed percentage of the top-line revenue — say 5% — until a return cap has been paid back. If revenue next month is $50,000, then the company pays the investor $2,500. However, if the revenue drops to $40,000 the month after, that month’s payment is $2,000.
Wait a minute! Aren’t you hurting the business this way? “Cash is King”
“Cash is King”. I agree, but what is really meant by cash? That’s a long story on it’s own and I will discuss it in the next episode.
What else do you need to know?
1. Revenue-based financing is a loan, but not the one you would get at a bank
Revenue Based Financing loans usually — at least at Seedlify — won’t require a personal guarantee. If your business fails, your personal possessions won’t take a hit. You are less likely to default in the first place as payments aren’t based on cash in your pocket, but on cash coming through the door. It’s literally a pay as you grow model.
2. Revenue-based financing is more expensive than bank loans, but cheaper than equity
In the example above, a $500,000 startup equity investment will cost the entrepreneur $5 million. In revenue based financing, at a 3x, it costs $1.5 million. That’s a 70% lower cost of capital.
But isn’t this discouraging for investors? Not really! Take a moment to do the math and think through the risks. You will discover that RBF greatly lowers the investment risk for the same return.
Revenue Based Financing is a Win-Win.
3. Revenue-based financing is not for every small business
Revenue Based Financing is not the best option for every small business or entrepreneur. RBF is not suitable for businesses with low gross margins as the investors are being paid a percentage of revenue, which ends up squeezing gross margins more. Businesses with SaaS, tech, or speciality services products are a better fit due to their high margins and scalability that allows for significant increase in cash flow despite paying the investor a percentage of revenue.
Did I lose you already? Okay, let’s break it down a bit!
Similar to equity financing, the RBF investor’s ROI depends directly on the company’s success. If the company grows faster than expected, the investor receives the return on investment more quickly than expected.
To conclude, deciding on a funding model is a personal decision that you have to make as a business owner. You need to consider your history, your credit, your assets, how fast do you need the money, how much can you afford to pay, and who you want to owe money to.