Debt vs equity financing
A lot is written about the advantages and pitfalls of debt and equity financing. Essentially, raising debt has the advantage of not diluting existing business ownership and control, whereas issuing equity does.
Debt comes at the expense of a higher risk to the business and the owners; the debt must be paid back by some fixed date. If it isn't, the owners may lose their entire business and perhaps more if they provide personal guarantees or collateral to support the loan.
Equity, in contrast, doesn't need to be repaid, and if the business is struggling, there's no pressure to make regular payments to the shareholders. In good times profits are shared among the owners as dividends. This makes equity a much more flexible and less risky source of financing.
The lucky business owner who has both of these options on the table (which is rare) needs to decide what's more important and suitable – flexibility and lower risk, or ownership and control.
What is revenue-based financing?
What if there was a third funding option, which would combine the best features of debt and equity financing while minimizing the negatives? Could you have flexible finance with performance-linked repayments, without permanently giving away a share in your business?
Revenue-based financing (RBF) is lesser-known but highly innovative third way between traditional debt and equity financing.
The essence of it, as the name suggests, is providing financing to a business in exchange for a share of its future revenues. Three parameters are usually agreed upfront besides the sum to be provided: the total amount to be repaid over time, the percentage of revenue shared with the provider of financing, and the payment frequency. Usually monthly, weekly or daily.
For example, if you borrow £25,000, your monthly turnover determines your loan term and your payments will align to an agreed percentage of your monthly sales. Therefore, if your turnover is £50,000 for one month and you have agreed to repay 10% of your monthly sales each month, you would pay £5,000. If it goes down to £45,000, you pay £4,500. This continues until the agreed amount is repaid.
- Revenue-based financing
- A form of business finance that is provided to small and growing companies in exchange for a share of their future revenues. It is often seen as a third funding option that sits between debt financing and equity financing.
The benefits of a revenue-based loan
So what's so special about this way of financing? Let’s take a closer look at the same four parameters we had to balance – ownership and control vs. flexibility and lower risk.
Like debt, revenue-based loans are non-dilutive; you don't lose a stake in your business so you maintain control over its destiny. Also, similarly to debt, there's a fixed amount to repay, which once reached, discharges you of any further obligations. So, maintaining ownership and control – check!
At the same time, your monthly repayments are directly linked to the performance of your business. They move up and down with your revenues making your financing a variable cost rather than a fixed cost to your firm. If your sales temporarily slow down, so would your repayments, making it a good option for seasonal businesses such as hotels.
Likewise if your sales grow quicker than expected, your monthly payments would be higher and you end up repaying your revenue advance quicker. Flexibility and lower risk – check!
As the final repayment amount is agreed from the outset, it might take a slightly different mindset to grasp how to budget. It’s relatively simple; in this instance, the business would just have to keep an agreed 10% of sales aside to repay the advance. There'll be interest on the loan, which can vary.
New funding for SMEs
Revenue-based financing as a product has never been a poster-child of finance, but the structure has been used for years by large businesses in industries as diverse as oil and gas, mining, media, and biotech. A few years ago a few companies emerged in the US, which brought revenue-based loans to SMEs for the first time.
The structure has been gaining popularity ever since, and companies like Lighter Capital, Rock and Hammer Ventures managed to build up multi-million dollar portfolios of revenue advances.