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 its invested capital is repaid, along with a multiple of that invested capital.
Mutual 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 cap.
CASE STUDY
Most RBF equity providers seek a 20-25% return on your 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 about $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 4-5 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 company 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 business. Other things being equal, the higher the revenue the company generates, the higher the monthly royalty payments the company 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 INCOME-BASED FINANCING AGREEMENT?
All businesses, especially technology ones, 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 solutions providers. The business may become eligible for traditional debt at lower interest rates.
As such, each revenue-based financing agreement outlines how a company can purchase or purchase 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.
In general, the capital provider expects to receive a specified percentage (or multiple) of its invested capital before the business owner can exercise the purchase option.
The business owner can exercise the option through a single payment or several lump sum payments to the capital provider. The payment buys a certain percentage of the royalty agreement. Invested capital and monthly royalty payments will be reduced by a proportional percentage.
Purchase option:
In some cases, the company may decide that it wants to buy and terminate the entire royalty financing arrangement.
This usually happens when the business 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 financing and you want to restructure financially.
In this scenario, the company has the option to purchase the entire royalty agreement for a predetermined multiple of the total principal invested. 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 restrictive debt covenants on how the company can use the funds.
The capital provider allows business managers to use the funds however 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 through 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 INCOME-BASED FINANCING FOR TECH BUSINESSES
Without equity, Without personal guarantees, Without traditional debt:
Tech 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 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 case of default.
The interests of the RBF capital provider are aligned with those of the business owner:
Tech companies can scale faster than traditional companies. As such, revenue can grow rapidly, allowing the company to pay royalties quickly. On the other hand, a poor product released to 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 hard 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 business revenue to grow rapidly so that it can share 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 industries.
RBF funds look for high-margin businesses that can comfortably afford the 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 arrangement is cheaper in financial and operational terms than a comparable capital investment.
RBF’s capital providers have no interest in participating in the management of the business. The scope of your active involvement 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 say 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 his invested capital when the business is sold. This is because he takes more risk, since he rarely receives financial compensation until the business is sold.
Capital cost:
The RBF capital provider receives payments every month. The business does not have to be sold to make a profit. 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 the finances of the business. RBF’s capital provider may 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 delivery of a term sheet for financing to the business owner and funds 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.