Ten years ago, there were few options available to tech founders outside of venture capital and traditional, interest-based loans. Now, alternative financing options are expanding horizons.
Led by revenue-based financing as well as the rise of decentralized financing (“DeFi” – blockchain), venture capital and banking institutions are no longer the only financial solutions on the block.
As with all change, some welcome it, some are unsure, others view it negatively. And today, the popular narrative around the arrival of alternative funding options often pits the old and new forms of financing against one another, as if in a zero-sum game. This thinking occurs when revenue-based financing is viewed as anti-VC, or vice versa.
The truth of the matter is quite the opposite of the popular narrative. There is no essential conflict between venture capital and revenue-based financing, or any other form of alternative financing for tech companies.
So why are different forms of financing often made into adversaries? As we see it, this stems mostly from the overall newness and general unfamiliarity of alternative forms of financing. And that’s on us to help clarify.
That’s why we’re rolling up our sleeves to help founders debunk three common misconceptions about revenue-based financing and its relation to venture capital.
1) Will revenue-based financing limit my ability to fundraise venture capital in the future?
When planning for the future of your company, every founder wants to keep as many doors open as possible. You never know how or when you might need extra capital, advice, and general support.
And who wants to fundraise capital now that will prohibit your ability to fundraise again in the future? The answer is no one. This is why the most common questions about revenue-based financing revolves around how it looks to future potential investors.
We can’t speak on behalf of all revenue-based financing firms or how every venture capitalist will react, but generally, the anxiety over possible objections to revenue-based financing can easily be minimized by how funding agreements are structured.
With our co-founders, we leveraged our extensive experience in venture capital and the startup world to craft terms that are sensitive to the needs of founders and future potential investors alike. So what have we done exactly?
We’ve built in early pay-off discounts in all of our term sheets. An early pay-off discount allows you to pay off the terms of the deal instantly at a discount. penalty. So how exactly does this work?
Let’s say you take this deal:
- $100,000 in revenue-based financing
- 36-month repayment timeline
- Our return is capped at 1.5x
But let’s say after 12 months, you’re ready to complete the repayment. Rather than repaying $150,000 (the 1.5x return on the initial $100,000), we’ll discount the repayment down to 1.3x, meaning $130,000 in repayments.
We do this because you shouldn’t be punished for accelerating your repayments if you want to clear it off your balance sheet. Though this isn’t super common in our experience, we’ve seen this approach taken by some of our partners including OpenReel, Gremlin, and Zype.
2) If I ever default on my revenue-based financing agreement, then will you seize our IP or try to take over the company?
When revenue-based financing is compared to venture capital, the narrative is often boxed into a story of equity vs. debt. In this scenario, equity is often viewed as the least risky for founders, since there’s no collateralization. When your company fails, venture capitalists don’t come after your IP or house.
With debt, in its interest-based form, funding is often collateralized with personal guarantees, meaning you could be subject to a bank chasing your company’s IP or your private wealth if you fall into default. It’s a black and white contrast, and there’s clearly a better option between the two: venture capital.
The problem is, revenue-based financing doesn’t actually fit into this polarized narrative. Since our funding is neither interest-based nor collateralized, we don’t operate like a typical bank issuing debt. Legally, our term sheets are set in stone so that we cannot come after you or your company in the case of default. Your control over the company, IP, and private assets are yours.
Much like venture capital, when one of our funding decisions doesn’t pan out, then that’s on us. We should mention here again though, there are certainly players in the alternative funding landscape that do have unfavorable terms for founders.
That includes revenue-based funding agreements that are collateralized or leave the door open to control over the company. You should always do proper due diligence on investors to ensure that you get the terms you want with the control you deserve.
3) Isn’t revenue-based financing much more expensive than equity financing?
Since venture capital has become the status quo for funding in tech, anything besides equity looks a bit like a pariah. And most tech entrepreneurs, de facto, rebuke debt or anything that looks comparable to it as bad for business. It’s either too expensive, or too bureaucratic due to personal guarantees, debt covenants, warrants, etc.
Yet if you lift the hood on this sentiment, you’ll see that there are plenty of situations in which equity is significantly more expensive for you than revenue-based financing.
All of this stems from an often forgotten fact: venture capital is inexpensive for founders in early-stage, high risk ventures and extremely expensive for founders in well-established businesses.
When a tech company is pre-revenue and it’s unclear whether product-market fit will ever be achieved, then equity is the only form of funding that really makes sense. Owning equity allows investors to hold something with (theoretically) unlimited upside. This is the only way to offset the massive risk of failure at an early stage.
Once a tech company is established with revenues and known growth costs though, then selling equity becomes much more expensive for founders. Side by side, the amount paid in royalties (how we structure our repayment terms – 4-9% of monthly gross cash receipts) is significantly lower than the value of equity, both on paper and when realized.
Here, it’s important for you to understand the cost of capital across all different types of funding. We address this in another article here.
Debunking the myth that revenue-based financing is anti-venture capital will take time, effort, and more and more education. And it certainly won’t happen overnight. Hopefully, these three questions we often encounter begin to paint the picture that there is nothing about revenue-based financing that hurts your ability to raise venture capital or risks your control over your company.
As we’ve touched on in our other article, revenue-based financing fits specific needs in specific scenarios in the development of SaaS companies.
If you’re considering revenue-based financing, then we’d love to discuss it with you. It’s not easy knowing what is best for your company, but we’re always here to talk through pro’s and con’s and ensure you tap the type of funding that fits your needs best. Reach out to us by filling out the form here, and we’ll get something on the calendar.