Revenue-based financing 101
Over the last decade, we’ve all witnessed a burst of new financial innovations. Whether it’s the rise of decentralized finance, neobanks, or improved digital payment infrastructure and tools, alternatives to the financial status quo continue to emerge. Even the landscape for financing tech companies is shifting.
Gone are the days where venture capital, venture debt, and traditional bank loans are your only viable funding solutions. With the rise of revenue-based financing, there’s some newly carved space between traditional debt and equity financing options. But as a new form of financing, there’s a lot of ambiguity about what it is, how it works, and when it’s the right fit for founders.
To provide clarity on these topics, we’re answering the most common questions we encounter when speaking with you, early-stage tech founders.
What is revenue-based financing?
Revenue-based financing is an investment tool, in which investors provide capital to a business in exchange for a percentage of ongoing revenues.
Rather than selling equity or taking on debt, we earn our returns through a monthly royalty payment based on your company’s cash collected on sales. Once you hit a predetermined investment return cap, you stop paying the royalty. There’s no pressure to exit or go public, nor do you have to lose sleep over dilution, as is common with venture capital. There are also no fixed monthly payments, personal guarantees, or debt covenants, as you would often find when receiving traditional bank loans or raising venture debt.
What types of companies and common scenarios fit revenue-based financing best?
With revenue baked into the mechanics of this type of investment, it shouldn’t come as a surprise that early-stage tech companies with cashflow make the best candidates. Revenues aside though, there are some common scenarios where revenue-based financing makes the most sense.
From years of partnering with early-stage companies, we’ve generally observed the following scenarios to be the best fit for revenue-based financing solutions:
1. You’re hiring new employees for growth
You’ve probably felt the tension between cash on hand and the desire to hire more talented team members. Whether you run a bootstrapped or venture-funded company, sometimes it’s a challenge pulling together the upfront capital required to expand the sales, marketing, or engineering teams.
In this situation, revenue-based financing is a great option. With the capital to hire, new team members fuel growth, allowing you to reinvest money back into your company. Revenue-based financing can help launch this virtuous growth cycle.
2. You’re expanding marketing efforts
Going hand in hand with hiring new employees, revenue-based financing is an efficient way to expand your marketing efforts. While traditional equity fundraising can take 6-12 months depending on the size of the round, revenue-based financing can have money in your bank account as quickly as a month, allowing you to rapidly expand your marketing or capitalize on new customer segments.
Like new hires, increasing marketing spend is another means of supercharging your company’s growth so you can continue to reinvest in your company.
3. You need a bridge between rounds
If you’re a venture-backed, early-stage company, revenue-based financing is a common method of avoiding difficult bridge rounds – whether it’s too expensive from existing investors or too risky as a red flag for future investors.
Instead, revenue-based financing can effectively fly below the radar and provide you with the capital you need to continue raising your next round. The added benefit here is that RBF prevents more dilution, keeping current and future investors happy, and can help you improve your company performance metrics for a future raise.
In each of these situations, the intention of a revenue-based investment is to provide what you need to maintain the healthy growth of your company without it costing you more than it has to in personal guarantees or equity dilution.
How does revenue-based finance stack up against venture capital?
Since venture capital is the dominant type of funding in tech, this is one of the most common questions in the marketplace now. Generally, some of the key differences between venture capital and revenue-based finance revolve around control, speed of fundraising, the stage of the company, and your overall approach to business. Let’s go through one by one what each means.
Control over your company
Where venture capital requires an equity stake in the company and often a seat on the board, revenue-based finance requires neither an equity sale nor a board seat. We take no control over your company – all ownership and decision-making remains fully controlled by you.
Speed of fundraising
Almost regardless of the size of the round, raising venture capital is always a time intensive process. There are very few funds that make decisions quickly, leaving many founders in no man’s land for extended periods of time. The same can equally apply to traditional bank loans, where applications can be drawn out over periods much longer than imagined.
With revenue-based finance, the turnaround time on investment decisions tends to be much faster. In our case with Novel, we know exactly what criteria and numbers we look for in early-stage companies, and it locks the investment process from start to finish into about 4-6 weeks.
Stage of Company
Revenue-based finance requires early-stage companies with revenue and moderate growth. That means, companies still seeking product-market fit are generally outside of the fold for this type of investment. That said, it should be clear that there is no one-size-fits-all type of funding.
Pre-revenue companies won’t benefit from revenue-based financing – venture capital is a much better option for you in that situation and the cost of that capital can make a lot of sense in that situation as well. If you’re running a capital intensive, research-oriented tech company, revenue-based financing is not going to provide that needed $50-100m+ in funding for a breakthrough innovation.
Does revenue-based financing play well with other types of funding?
Often, different types of funding are pitted against each other in an adversarial way. And the way it really works couldn’t be any farther from the truth.
Revenue-based finance plays very well in the sandbox alongside venture capital, venture debt, traditional debt, angel financing, etc. We’ve invested in plenty of early-stage companies that take revenue-based financing while closing a round of venture capital at the same time, or in-between rounds of fundraising venture capital. In these situations, the extra investment is often attractive to founders without any additional sale of equity in the company.
How does revenue-based finance compare to interest-based loans?
It’s easiest to think of the answer to this question on two different levels. One is your company, and the other is for you as a private person. Let’s first start with your company.
Compared to a typical bank loan, revenue-based financing affords you more flexibility with repayment terms. Specifically, there is no fixed monthly payment amount. So if your revenue has a momentary dip, revenue-based financing allows your monthly repayments to scale accordingly. This alleviates the pressure that traditional bank loans put on entrepreneurs – always a serious drag on your psyche.
Now on the other side, for you as a private individual, revenue-based financing requires no collateral or personal guarantees. When banks issue a typical loan, personal guarantees are very difficult to avoid. This means, banks have recourse to come after your private assets in the case the loan isn’t repaid in full. From the bank’s perspective, this is a risk mitigation tactic, but one that always feels a little (rightfully!) haunting.
In concrete terms, our revenue-based financing returns are capped at 1.2x to 1.9x the capital invested, royalty payments are between 4% and 9% of gross monthly cash receipts, and we usually invest a lump sum of around 30% of your company’s annual revenues (both recurring and non-recurring).
How do you think about cost of capital?
Between venture capital, venture debt, bank loans, and revenue-based financing, it can be a challenge to understand how the costs of capital compare. Frankly, they all differ so widely that figuring out how to make it apples to apples is the first step. That’s why we recommend using a framework for cost of capital analysis like an annualized cost percentage (ACP) number.
This simple formula is a great way to create an accurate comparison to understand how much each form of financing will cost you on an annual basis. Though not a perfect calculator, this method will give you a much better sense of how all your options stack up against each other and most importantly how much each will impact your business.
What makes Novel GP the right partner?
At Novel, we’ve been in the trenches. Each member of our team has first-hand experience with early-stage technology companies and the challenges entrepreneurs face. That’s why we are conscientious of your time and energy when fundraising, making our investment decisions fast and providing full process transparency.
With our experience, we’re also happy to lend input to support your strategic planning, sales, and hiring efforts, whether it’s through regular office hours or assessing potential hires.
As we mentioned, we are always looking to partner with early-stage founders with >$500,000 in annual revenues and a 30% YoY growth rate among other financial and growth metrics. If you fit that profile and revenue-based financing sounds like it meets your needs, then let’s talk about how we can help you grow by contacting us here.