Is Revenue-Based Financing Right for Your Business?

If you’re a business owner seeking an infusion of capital to help your company grow, chances are you’ve been confused by the plethora of funding options out there. The lower middle and middle markets are flush with different types of capital providers, each with varied fee structures and interest rates.

We recently spoke with the team at Decathlon Capital Partners to learn more about one option: revenue-based financing. With flexible terms and ability to fuel growth, revenue-based financing can be a valuable but often overlooked funding option for middle market businesses.

What is revenue-based financing?

Revenue-based funding solutions are designed to offer companies the flexibility, patience, and agility of equity with the non-dilutive benefits of debt. Revenue-based financing models are typically structured with a multi-year repayment term where a company agrees to pay a fixed percentage (usually about 1% to 3%) of the revenues they generate each month to their investor.

To retire a revenue-based funding investment, a company typically makes monthly payments until a pre-defined return multiple, internal rate of return (IRR), or terminal date is reached, at which point the investment obligation is retired. Ideally, the structure incentivizes both the company and the investor to support future revenue growth.

Unlike some other approaches to growth funding, revenue-based financing solutions typically don’t have any other fees, warrants, or hidden costs involved. Because payments are tied directly to revenues, the mechanics are very transparent; companies get a clear and accurate picture of their total cost of capital right upfront.

Revenue-based funding providers often hold a junior lien at the company-level, but do not require business owners to take on any personal financial exposure or risk in the form of personal guarantees.

Are there any risks associated with revenue-based financing? If so, what should business owners look out for?

While most revenue-based funding solutions are very flexible and designed to accommodate the normal ebbs and flows of a growth-focused company’s lifecycle, there are definitely a few items that business owners should carefully evaluate when determining if revenue-based funding is an appropriate option.

First, business owners should honestly assess their plans for growth. Most revenue-based funding providers do not need to see hockey-stick style growth to be interested in supporting a company. Business owners should focus on developing realistic growth plans — if there are material revenue shortfalls over time, a company may end up facing a larger than expected balloon payment at the end of the investment term.

Business owners should also be aware of the tax issues that are often involved with revenue-based financing structures. While an experienced revenue-based funding firm will ensure that everything is structured, managed, and reported in a fully tax-compliant manner, there are a range of nuances inherent in the treatment of revenue-based financing models. If things are structured improperly, a company may have to forfeit their ability to deduct interest payments as a result.

Finally, like the evaluation of any funding partner, business owners should focus on who they will actually be working with and who will hold their paper post-investment. Some revenue-based funding providers really just focus on originating and underwriting investments, then sell the obligation down the line to other third-party financial investors. Business owners should fully understand who will actually hold the obligation so that that incentives for a successful long-term partnership are aligned.

When do companies usually seek revenue-based financing options?

Growth-focused companies typically pursue revenue-based funding in one of two scenarios. In the first situation, a business owner is reluctant to dilute the value of the business by selling an ownership portion to an equity investor. These business owners often don’t want to bring on a new partner because they want to keep the value they are going to create, but still need a capital infusion to support growth.

The second scenario occurs when business owners find traditional debt options, with tight financial covenants and relatively short loan terms, constraining. These business owners often feel that traditional debt products will limit their agility and not provide enough capital and operating runway for the company to maximize its investment in long-term enterprise value creation.

Can a business be too small or too big for revenue-based financing?

Most institutional revenue-based financing providers do have some minimum revenue threshold requirements, but the concept of a revenue-based financing structure can work for any size business when structured properly. Most revenue-based funding groups have a trailing twelve-month revenue requirement of at least $2 million, but if a company has a high percentage of contractually recurring revenue (SaaS business, subscription business, etc.) then the historical revenue thresholds can be lower.

At the upper end of the spectrum, many companies with revenue profiles north of $50 million also take advantage of the benefits of a revenue-based funding approach.

In your opinion, what’s the biggest misconception business owners have about revenue-based financing?

We regularly see two areas of confusion related to revenue-based funding. First, many business owners incorrectly assume that revenue-based funding is somehow similar to factoring or purchase order financing in the sense that the funding must be tied to a purchase order, contract, or receivable — this is not true.

The repayment terms for revenue-based funding solutions are measured in years, not months or quarters. As a result, the funding is not geared around a company’s receivables or purchase orders and the investor generally does not have any involvement with a company’s customers, receivables, or bank accounts.

The second area of misconception we see in the marketplace relates to many businesses thinking that they must be a technology, SaaS, or recurring revenue company in order to qualify for revenue-based funding.

While revenue-based funding works very well for each of those categories, revenue-based funding solutions can also make sense for companies in a wide range of other markets and business segments such as business services, healthcare, and consumer or commercial products.