WHAT IS INCOME BASED FINANCING?
Revenue-Based Financing (RBF), also known as Royalty-Based Financing, is a unique form of financing provided by RBF investors to small and medium-sized businesses in exchange for an agreed percentage of a company’s gross revenue.
The capital provider receives monthly payments until their 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.
TERMINOLOGY
– Monthly payments are called royalty payments.
– The percentage of revenue paid by the company to the capital provider is called the royalty rate.
– The multiple of the invested capital that the company pays to the capital provider is called the ceiling.
CASE STUDY
Most providers of RBF capital are looking for a 20% to 25% return on their investment.
Let’s use a very simple example: If a company receives $1 million from an RBF capital provider, the company is expected to pay $200,000 to $250,000 per year to the capital provider. That equates to around $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 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.
Suppose the business produces $5 million in gross revenue per year. As stated above, they received $1 million from the capital provider. They are paying $200,000 to the investor each year.
The royalty rate in this example is $200,000/$5M = 4%
VARIABLE ROYALTY RATE
Royalty payments are proportional to the top line of the business. All things being equal, the higher the revenue 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, business owners are being punished for their hard work and success in growing the business.
To remedy this problem, most royalty financing agreements incorporate a variable royalty rate schedule. In this way, the higher the income, the lower the royalty rate applied.
The exact schedule of the sliding scale is negotiated between the parties involved and is clearly outlined in the term sheet and contract.
HOW DOES A BUSINESS GET OUT OF THE REVENUE-BASED FINANCING AGREEMENT?
All businesses, especially technology businesses, which grow very quickly, will eventually outgrow their need for this form of financing.
As the company’s balance sheet and income statement strengthen, the company will move up the financial ladder and attract the attention of more traditional financial solution providers. The business may become eligible for traditional debt at lower interest rates.
As such, each revenue-based financing agreement outlines how a business can buy or buy out the capital provider.
Purchase option:
The business owner always has the option to purchase a portion of the royalty agreement. The specific terms for a purchase option vary for each transaction.
Generally, the capital provider expects to receive a certain specified percentage (or multiple) of its invested capital before the business owner can exercise the purchase option.
The business owner can exercise the option by making a single payment or multiple lump sum payments to the capital provider. The payment buys a certain percentage of the royalty agreement. The capital invested and the monthly royalty payments will be reduced by a proportional percentage.
Purchase option:
In some cases, the company may decide that it wants to buy out and terminate the entire royalty financing agreement.
This usually happens when the company is sold and the acquirer decides not to continue with the financing agreement. Or when the business has become strong enough to access cheaper sources of finance and wants to restructure financially.
In this scenario, the company has the option to purchase the entire royalty agreement for a predetermined multiple of the total invested capital. This multiple is commonly known as a cap. The specific terms for a purchase option vary for each transaction.
USE OF FUNDS
There are generally no restrictions on how a company can use RBF capital. Unlike a traditional debt agreement, there are little or no debt agreements that restrict how the company can use the funds.
The capital provider allows business managers to use the funds as they see fit to grow the business.
Acquisition Financing:
Many technology companies use RBF funds to acquire other companies in order to accelerate their growth. RBF capital providers encourage this form of growth because it increases the income to which your royalty rate can be applied.
As the business grows by acquisition, the RBF fund receives higher royalty payments and therefore benefits from the growth. As such, RBF financing can be a great source of acquisition financing for a technology company.
BENEFITS OF REVENUE-BASED FINANCING FOR TECHNOLOGY COMPANIES
No equity, No personal guarantees, No traditional debt:
Technology companies 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 place little or no value on them. This makes it extremely difficult for small and medium tech companies to access traditional financing.
Revenue-based financing does not require a business to secure the financing with any assets. Personal guarantees are not required from business owners. In a traditional bank loan, the bank often requires personal guarantees from the owners and goes after the personal assets of the owners in the event of default.
The interests of the RBF capital provider are aligned with those of the business owner:
Technology companies can scale faster than traditional companies. As such, revenue can add up quickly, allowing the company to pay royalties quickly. On the other hand, a poor product launched on the market can destroy business revenue 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 difficult times, the company makes exactly the same debt payments to the bank.
The interests of an RBF capital provider are aligned with those of the business owner. If business income declines, RBF’s capital provider receives less money. If business income increases, the capital provider receives more money.
As such, the RBF provider wants the business revenue to grow rapidly so that they can share in the benefits. All parties benefit from 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 companies in many different sectors.
RBF funds look for high-margin businesses that can comfortably afford monthly royalty payments.
No equity, no board seats, no loss of control:
The capital provider shares in the success of the business but receives no share in the business. As such, the cost of capital in an RBF deal is cheaper in financial and operational terms than a comparable equity investment.
RBF’s capital providers have no interest in participating in the management of the business. The scope of your active participation is to review the monthly revenue reports received from the business management team to apply the appropriate RBF royalty rate.
A traditional equity investor expects to have a strong voice in how the business is run. He expects a seat on the board and some level of control.
A traditional equity investor expects to receive a significantly higher multiple of their invested capital when the business is sold. This is because he takes more risk, as he rarely receives financial compensation until the business is sold.
capital cost:
The RBF capital provider receives payments every month. It is not necessary for the business to be sold to obtain a return. This means that the RBF capital provider can afford to accept lower returns. That is why it is cheaper than traditional capital.
On the other hand, RBF is riskier than traditional debt. A bank receives fixed monthly payments regardless of business finances. RBF’s capital provider stands to lose its entire investment if the company goes bankrupt.
On the balance sheet, RBF sits between a bank loan and shares. 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 a term sheet for financing being provided to the business owner and funds being disbursed to the business can be as little as 30-60 days.
Businesses that need money right away can benefit from this fast turnaround time.
