WHAT IS REVENUE-BASED FINANCING?
Revenue-based financing (RBF), also known as royalty-based financing, is a unique form of financing provided by RBF investors to small- to mid-sized businesses in exchange for an agreed-upon percentage of a business’ gross revenues.
The capital provider receives monthly payments until his invested capital is repaid, along with a multiple of that invested capital.
Investment funds that provide this unique form of financing are known as RBF funds.
- The monthly payments are referred to as royalty payments.
- The percentage of revenue paid by the business to the capital provider is referred to as the royalty rate.
- The multiple of invested capital that is paid by the business to the capital provider is referred to as a cap.
Most RBF capital providers seek a 20% to 25% return on their investment.
Let’s use a very simple example: If a business receives $1M from an RBF capital provider, the business is expected to repay $200,000 to $250,000 per year to the capital provider. That amounts to about $17,000 to $21,000 paid per month by the business to the investor.
As such, the capital provider expects to receive the invested capital back within 4 to 5 years.
WHAT IS THE ROYALTY RATE?
Each capital provider determines its own expected royalty rate. In our simple example above, we can work backwards to determine the rate.
Let’s assume that the business produces $5M in gross revenues per year. As indicated above, they received $1M from the capital provider. They are paying $200,000 back to the investor each year.
The royalty rate in this example is $200,000/$5M = 4%
VARIABLE ROYALTY RATE
The royalty payments are proportional to the top line of the business. Everything else being equal, the higher the revenues that the business generates, the higher the monthly royalty payments the business makes to the capital provider.
Traditional debt consists of fixed payments. Therefore, the RBF scenario seems unfair. In a way, the business owners are being punished for their hard work and success in growing the business.
In order to remedy this problem, most royalty financing agreements incorporate a variable royalty rate schedule. In this way, the higher the revenues, the lower the royalty rate applied.
The exact sliding scale schedule is negotiated between the parties involved and clearly outlined in the term sheet and contract.
HOW DOES A BUSINESS EXIT THE REVENUE-BASED FINANCING ARRANGEMENT?
Every business, especially technology businesses, that grow very quickly will eventually outgrow their need for this form of financing.
As the business balance sheet and income statement become stronger, the business will move up the financing ladder and attract the attention of more traditional financing solution providers. The business may become eligible for traditional debt at cheaper interest rates.
As such, every revenue-based financing agreement outlines how a business can buy-down or buy-out the capital provider.
The business owner always has an option to buy down a portion of the royalty agreement. The specific terms for a buy-down option vary for each transaction.
Generally, the capital provider expects to receive a certain specific percentage (or multiple) of its invested capital before the buy-down option can be exercised by the business owner.
The business owner can exercise the option by making a single payment or multiple lump-sum payments to the capital provider. The payment buys down a certain percentage of the royalty agreement. The invested capital and monthly royalty payments will then be reduced by a proportional percentage.
In some cases, the business may decide it wants to buy out and extinguish the entire royalty financing agreement.
This often occurs when the business is being sold and the acquirer chooses not to continue the financing arrangement. Or when the business has become strong enough to access cheaper sources of financing and wants to restructure itself financially.
In this scenario, the business has the option to buy out the entire royalty agreement for a predetermined multiple of the aggregate invested capital. This multiple is commonly referred to as a cap. The specific terms for a buy-out option vary for each transaction.
USE OF FUNDS
There are generally no restrictions on how RBF capital can be used by a business. Unlike in a traditional debt arrangement, there are little to no restrictive debt covenants on how the business can use the funds.
The capital provider allows the business managers to use the funds as they see fit to grow the business.
Many technology businesses use RBF funds to acquire other businesses in order to ramp up their growth. RBF capital providers encourage this form of growth because it increases the revenues that their royalty rate can be applied to.
As the business grows by acquisition, the RBF fund receives higher royalty payments and therefore benefits from the growth. As such, RBF funding can be a great source of acquisition financing for a technology company.
BENEFITS OF REVENUE-BASED FINANCING TO TECHNOLOGY COMPANIES
No assets, No personal guarantees, No traditional debt:
Technology businesses are unique in that they rarely have traditional hard assets like real estate, machinery, or equipment. Technology companies are driven by intellectual capital and intellectual property.
These intangible IP assets are difficult to value. As such, traditional lenders give them little to no value. This makes it extremely difficult for small- to mid-sized technology companies to access traditional financing.
Revenue-based financing does not require a business to collateralize the financing with any assets. No personal guarantees are required of the business owners. In a traditional bank loan, the bank often requires personal guarantees from the owners, and pursues the owners’ personal assets in the event of a default.
RBF capital provider’s interests are aligned with the business owner:
Technology businesses can scale up faster than traditional businesses. As such, revenues can ramp up quickly, which enables the business to pay down the royalty quickly. On the other hand, a poor product brought to market can destroy the business revenues just as quickly.
A traditional creditor such as a bank receives fixed debt payments from a business debtor regardless of whether the business grows or shrinks. During lean times, the business makes the exact same debt payments to the bank.
An RBF capital provider’s interests are aligned with the business owner. If the business revenues decrease, the RBF capital provider receives less money. If the business revenues increase, the capital provider receives more money.
As such, the RBF provider wants the business revenues to grow quickly so it can share in the upside. All parties benefit from the revenue growth in the business.
High Gross Margins:
Most technology businesses generate higher gross margins than traditional businesses. These higher margins make RBF affordable for technology businesses in many different sectors.
RBF funds seek businesses with high margins that can comfortably afford the monthly royalty payments.
No equity, No board seats, No loss of control:
The capital provider shares in the success of the business but does not receive any equity in the business. As such, the cost of capital in an RBF arrangement is cheaper in financial & operational terms than a comparable equity investment.
RBF capital providers have no interest in being involved in the management of the business. The extent of their active involvement is reviewing monthly revenue reports received from the business management team in order to apply the appropriate RBF royalty rate.
A traditional equity investor expects to have a strong voice in how the business is managed. He expects a board seat and some level of control.
A traditional equity investor expects to receive a significantly higher multiple of his invested capital when the business is sold. This is because he takes higher risk as he rarely receives any financial compensation until the business is sold.
Cost of Capital:
The RBF capital provider receives payments each month. It does not need the business to be sold in order to earn a return. This means that the RBF capital provider can afford to accept lower returns. This is why it is cheaper than traditional equity.
On the other hand, RBF is riskier than traditional debt. A bank receives fixed monthly payments regardless of the financials of the business. The RBF capital provider can lose his entire investment if the company fails.
On the balance sheet, RBF sits between a bank loan and equity. As such, RBF is generally more expensive than traditional debt financing, but cheaper than traditional equity.
Funds can be received in 30 to 60 days:
Unlike traditional debt or equity investments, RBF does not require months of due diligence or complex valuations.
As such, the turnaround time between delivering a term sheet for financing to the business owner and the funds disbursed to the business can be as little as 30 to 60 days.
Businesses that need money immediately can benefit from this quick turnaround time.