“The RBF structure can be a great option for profitable companies looking for a straightforward way to raise funding without dilution, change of control, or a personal guarantee” – Andy Sack

A few months back we wrote an article, “Choose the Right Funding for Your Startup”, in which we talk about available funding options at each startup stage. You can also check Fred Wilson’s blog post, “Financing Options For Startups” in which he gives a list of possible funding alternatives for your startup. He had a series on this and wrote about each alternative he suggests. (Check Friends and Family, Contests/Prizes/Accelerator Programs, Government Grants,  Customer Financing, Vendor Financing, Convertible Debt, Preferred Stock, Venture Debt, Capital Equipment Loans & Leases, Bridge Loans, and Working Capital Financing).

Nevertheless, there is one pretty appealing funding alternative we haven’t covered yet. And that is Revenue Based Finance (RBF). Today we are going to talk about what RBF is actually about, how it works, who should use it/ who should not use it, and what benefits it offers.

1. What is RBF? – RBF in fact is not such a new funding alternative but it’s recently been capturing attention in the world of growth finance and early-stage technology funding. Andy Sack, founder and CEO of Lighter Capital (previously known as RevenueLoan, a company created to address the needs of business owners with a new form of growth funding – the RBF) gives the following definition: “A revenue-based finance (RBF) investment provides capital to a business by ‘selling’ an ongoing percentage of a company’s future revenues to the investor”.  Thus an investor gives capital to a company in exchange for a specified percentage of gross revenues. It is hybrid of bank debt and venture capital, says Sack. RBF has its roots in the mining, entertainment, and drug development industries. “Arthur Fox of Royalty Capital Managementhas done royalty-based financing on the East Coast, since 1990s”, says Sack in one of his interviews.

2. How does it work? – An investor gives cash to a startup in exchange for a percentage of startup’s revenues for a fixed period, or until a maximum payback “cap” is reached. This has nothing to do with ownership since on one hand it allows the owner to access cash without giving up control to an investor, and on the other hand the owner is not required to guarantee the repayment with personal assets as a bank often requires. “The percentage of revenue or royalty, as it is often referred to, is usually between 1-10% of monthly gross sales, and the repayment cap often varies from a multiple of 2x-5x of the invested capital”, explains Partners in Demand. Thomas Thurston gives a simple example on this: “a startup with $1 million in revenue could get $150K in exchange for giving 5% of its monthly revenue to an RBF investor until $450K is repaid (assuming a 3x cap)”.

3. Who should use it? – Sack claims that RBF is “most appropriate for companies already generating revenues but without hard assets typically required to get bank loans. It’s especially applicable for companies that have lumpy, seasonal, or hard to predict revenues”.  To be more specific, Partners in Demand gives the following explanations: “The type of deals best suited for RBF are startups with $1-$10M in revenue that need an extra $100K-$3M. For it to work well, startups need a 50% or higher gross margins, or the royalty could cause drain on the business. This type of financing seems ideal for high-margin software and service startups which have already started generating revenue”.

4. Who should not use it? The Seed and Startup Capital Blogadvisesthat RBF is not considered acceptable for those rare startups that have the potential to go through an IPO. Why? In such cases where investors see a huge potential, where they see the startup as the next big thing, they will most likely want to participate as equity investors so that they can get their 50x or 100x return on investment. “Equity financing makes the most sense whenthe company truly has the potential to hit it big.  In the vast majority of cases, the potential is far less. Most startups will not be the next Google, Amazon, or Facebook.  It’s these other types of companies that make the most sense for revenue-based financing”, explains The Seed and Startup Capital Blog. Further, in one of his guest blog posts for StartupLawBlog.com, Randall Lucas, points out 2 situations when a startup should not go for RBF and those are:

• Declining Marginal Margins: The rationale behind is that if you owe 10% of your revenue to an investor, but your marginal gross margin drops to 10% then the optimal thing to do is stop selling. “And that’s a damn weird bind to put an entrepreneur or a company into. ‘Perverse incentives’ kick in at that point — and neither you nor the financier is likely to be happy”, explains Lucas.

• One-Way Ticket to Crazytown. “If the VC train has left the valuation station — and it’s on a one-way ticket to crazytown — you might find yourself able to raise funds at a premoney valuation that even YOU, the optimistic entrepreneur, don’t believe in. If that’s true — and it’s definitely been the case in ancient (late ’90s) and arguably in recent (late 2000s) history — then selling off a percentage of your revenues is almost certainly a worse deal for you. After all, the reason why RBF is a win for investors is that it repays on a variable basis, based on revenue collection, making for (usually monthly) cash flow returns”, says Lucas.

5. Why is RBF good for startups? - First, with RBF you don’t sell percentage of company. What you sell is a percentage of revenue, thus it can often be more attractive than either debt or equity, says Lucas.

Second, Sack points out the inherent variability of RBF as a great benefit. “Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense. Thus RBF payments automatically ramp up and down along with a business”, continues Sack. In Sack’s guest blog post published on Wilson’s blog, you can read more about the benefits that RBF offers to both, investors and owners.

Third, RBF ends the conflict over valuation and the need for a single event “exit strategy” (IPO, sale or refinancing), writes RockWaterCapital.com. Follow this link to read more about the benefits that RBF offers to both, investors and owners.

To sum up, RBF can be a very appealing funding option. Moreover, as Thurston assures it will most probably create a big market that it will look a lot bigger than equity market investing, although it won’t replace equity funding. He says: “It’s like angioplasty. It didn’t replace heart surgery, but it created a much larger market for preventive heart care”.

Nevertheless, one must keep in mind that RBF may not be the best funding option for all businesses. “In the right circumstances, the hybrid approach of revenue-based finance for startup funding can have advantages over traditional debt or equity, but there are admittedly situations where the more traditional options still make sense – such as restaurants or infrastructure-heavy startups.There are clearly different scenarios where any number of Fred’s financing alternatives could prove more appropriate for your business, but the revenue-based loan structure can be a great option for profitable companies looking for a straightforward way to raise funding without dilution, change of control, or a personal guarantee”, explains Sack.

Think about your business, your strategy, the stage you are currently at, discuss with peers, investors, mentors, consultants and then decide if RBF best suits your business or maybe you should go for another financing alternative.