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Explained: Revenue-Based Financing for Early Stage Companies

There are a variety of popular investment options for early-stage businesses. One lesser-known tool, revenue-based financing, may be a useful complement or alternative to venture capital or banks.

As many founders know, banks are often reluctant to offer loans for early-stage companies that do not have meaningful assets or a history of profitability. And, venture capital firms are typically only interested in companies that will return at least 10x within 5 to 7 years.

Revenue-based financing, also known as royalty-based financing or revenue sharing, is a flexible financing option that is accessible to a wider range of growing businesses.

What is Revenue-Based Financing?

Revenue-based funding is a straightforward investment tool, in which investors provide capital to a business in exchange for a percentage of ongoing revenues.

Instead of buying equity and waiting for an exit, revenue-based financing investors make an investment and earn returns via a monthly royalty payment based on the company’s cash collected from sales. Once a company hits a predetermined investment return cap, the company stops paying the royalty.

The History of Revenue-Based Financing

While it’s gained recent popularity for funding early-stage companies, revenue-based financing has been around for decades.

Revenue-based financing traces its roots to mineral mining companies that faced a scarcity of capital options to fund their operations. Investors began funding the mining operations in exchange for a percentage of the minerals produced and sold at a mine. 

Investors began implementing the revenue-based financing model on early-stage technology companies in the 1980s. Since then, the industry has grown rapidly. Currently, there are over 25 revenue-based financing firms, compared to less than five only 10 years ago. Decathlon Capital estimates that the revenue-based financing market has grown 10x in the last decade. Now, revenue-based financing is used in a wide variety of industries, including pharmaceuticals, e-commerce, software, technology, and more.

How Does Revenue-Based Financing Work?

With revenue-based funding, investors provide a lump sum of capital in exchange for a fixed percentage of monthly revenue. The initial amount, up to a predetermined total amount (return cap), is paid back by the borrower.

There are a variety of revenue-based financing firms, and the best fit for you depends on your capital needs. Firms can provide investments of anywhere from $10,000 to upwards of $5 million. At Novel specifically, we provide investments of $100,000 to $2 million with investment amounts of up to 30 percent of a company’s annual revenue. 

A company’s monthly royalty payment is not a fixed amount, but rather is a fixed percentage of the company’s gross cash receipts. This instrument allows for a flexible payment depending on how a company’s sales are doing. Depending on the provider, total royalties paid are capped at 1.5x to 3x of the amount invested, and monthly payments range from 4 to 12 percent of the company’s gross cash receipts.

What Companies Can Access Revenue-Based Financing?

Revenue-based financing is accessible to a far wider range of companies than venture capital or banks.

Companies that are likely a great fit for revenue-based financing are those that have bootstrapped their growth, have prior angel or venture capital investment, that are looking for a bridge round, or are looking to finish off a current fundraise. At Novel, we prefer to work with founders who need operational help and who are seeking capital targeted for revenue growth rather than research and development of a product or service.

Most revenue-based financing firms invest primarily in companies with a history of producing revenue. Again, the best firm for you depends on your industry, size, and revenue history. Novel, specifically, invests in early stage B2B SaaS companies with at least 2 years of revenue. 

How does Revenue-Based Financing Compare to Venture Capital? 

There are a variety of factors to consider when making the decision between traditional venture capital in the form of Series A funding and revenue-based financing.

Series A funding is beneficial for firms with very high growth that are looking to raise a significant amount of funding and not take on debt. This method, however, requires giving investors a stake in your company, thus reducing your control and ownership. When thinking about Series A funding, companies should carefully evaluate whether they are ready for high growth funding, as premature scaling can be incredibly risky.

For companies looking for non-dilutive capital, revenue-based financing may be the better option. Revenue-based funding also allows for quicker turnaround, if a company needs access to capital on a shorter timeline. However, this requires a commitment of your future revenue, which may not always be feasible.

Revenue-based funding doesn’t require equity so there’s no valuation negotiation, nor does it require any seat on a company’s board. Most revenue-based financing firms cap returns at an agreed amount. That allows founders to know their cost of capital from the onset and allows them to better manage future capital needs.

How does Revenue-Based Financing Compare to Banks? 

Banks operate on slower timelines and present certain hurdles to an early-stage company. Often, they’ll require assets, such as buildings or expensive equipment, to collateralize a loan. Loans also typically have rigid repayment terms and require personal guarantees or personal collateral

Comparatively, revenue-based financing is more broadly accessible to companies earlier in their journey. Revenue-based financing firms such as Novel do not require collateral or personal guarantees.

How does Revenue-Based Financing Compare to Angel Investors?

Angel investment typically entails significant time for due diligence and attracting and negotiating with several investors. Angel investments also result in ownership dilution and some loss of control. 

Comparatively, revenue-based financing firms such as Novel do not take equity in their portfolio companies, allowing for full founder control.

That said, most revenue-based financing investors will invest alongside angels to complement a funding round.

Venture Debt?

Venture debt, or venture lending, is a type of financing for venture equity-backed companies that lack the cash-flow or assets for more common forms of debt financing or that want greater flexibility.

Venture lending is often a complement to equity financing and is often structured as a three-year term loan or a series of loans with warrants for company stock. This type of financing can take many forms, and funds often have different investment criteria. Venture debt usually requires a sizable recent equity investment and will often be a percentage of that most recent raise. At Novel, we do not require our portfolio companies to be venture-backed.

Debt Covenants

A debt covenant, also known as a banking or financial covenant, is an agreement between a company and a creditor that the company will operate within a certain set of rules established by the lender. These agreements are intended to align the interests of the lender and borrower. 

Advantages of Revenue-Based Financing

In addition to its transparent cost and flexible repayment terms, revenue-based financing can serve as a complement to an investment round. Revenue-based financing investors can invest alongside angel investors and equity venture capital.

In our experience, most previous investors appreciate the flexibility of Novel’s approach, minimal to no dilution, and the tactical sales help we provide. Oftentimes, revenue-based financing can help companies bridge the funding gap between valuation milestones. This method better positions them to raise future rounds at more favorable terms.

Getting revenue-based financing is also a faster, more transparent process. Novel makes quick investment decisions and funds companies in 4 to 6 weeks. Novel is transparent with companies throughout its evaluation process and quickly lets founders know if we won’t be investing.

Revenue-Based Financing Tax Treatment

Tax treatment for revenue-based financing is similar to any other loan. A portion of a company’s royalty payments are tax-deductible and will vary based on the amount a company has paid in a year.

What if a Company’s Revenue Decreases?

One of the benefits of revenue-based financing is its flexibility. In revenue-based financing, payments are based on a percentage of a borrower’s cash collections. When your revenue or cash collections decrease, your payments decrease. The opposite is also true—if your revenues increase, so too will your royalty payment.

When your revenues decrease, your payments become smaller, taking longer for you to pay back the initial investment. Unlike other types of debt, however, Novel’s revenue-based financing method means borrowers pay only when they collect cash. This method prevents cash flow issues typically associated with, for example, a term loan from a bank.

At Novel we do not require minimum payments. So, if you have a tough month or a tough quarter, the terms we agreed to at the outset remain in place, and your payment decreases with your revenue.

Misconceptions of Revenue-Based Financing

Venture capital is not the only financing option for early-stage companies — though it is often the only option pursued by founders.

It’s important to conduct an honest assessment of where your business is and your vision and goals. That will not only inform a better fundraising plan but will also save you time and money

If your company is growing 150 percent year-over-year, venture capital funding might be a good fit. On the other hand, if your business is growing at 40 percent a year, there are likely better options that will be faster, non-dilutive, and a better fit your company’s trajectory.

Investors Can Play Nice Together

Founders sometimes believe they can only choose one type of investor for a funding round. In reality, revenue-based financing will often work well alongside other investments from banks, angels, or venture capitalists.

Hitting Milestones with Revenue-Based Financing

Founders should give careful consideration to why they are fundraising and what ends their new capital will serve. When evaluating capital options, consider what amount of funding you’d need to accomplish the next milestone that adds genuine value to your company. 

Without that understanding, you’ll be spending a lot of money to learn while your company is being diluted in the process.

Personal Guarantees

Unlike many traditional business loans that force founders to collateralize their home, car or other assets, Novel’s revenue-based financing model doesn’t need personal guarantees. In revenue-based financing, founders can land meaningful growth capital for the company without the fear of losing personal property. 

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