Small and growing businesses frequently find themselves in a cash crunch. To acquire more cash, businesses are usually limited to a bank loan or an investor who will buy a piece of your business for the capital infusion. There is a third alternative – Revenue Based Financing (RBF).
Types of Revenue-Based Financing
There are two varieties of Revenue-Based Financing
- A loan based on the business’ recurring revenue stream
- Royalty or a percentage of each future sale usually used in the life sciences sector and by Kevin O’Leary on the popular TV show “Shark Tank”
Since all the payments occur as products or services are sold or consumed, both varieties are the same.
With Revenue-Based Financing, the payments and terms are variable from month to month. Furthermore, the loan is satisfied when the borrower repays the original amount plus a pre-determined multiple.
Kevin O’Leary’s approach to royalties is slightly different. He usually does not ask for much equity but does set a royalty rate of $X for each unit sold until his total grossed-up loan is repaid. At that point, the royalty is decreased, and the lower amount is paid for perpetuity. For example, Mr. O’Leary loans the presenter $100,000 and collects $10 for each item sold until he receives $250,000, at which point he keeps receiving $2.75 per item sold forever.
Advantages of Revenue-based Financing
- The lender does not usually require any equity.
- Payments are variable and solely depend on sales.
- When business is slow, there is minimal loan repayment.
- The loan is generally straightforward with no restrictive terms.
- RBF investments do not usually require a seat on the Board of Directors and there are no discussions about how the company was valued.
- A significant advantage is that the interests of the RBF investor and company are aligned; each side only gets paid when something is sold.
Disadvantages of Revenue-Based Financing
- The most compelling requirement is that the borrower must be generating predictive revenue.
- The product must have excellent gross markings with little pressure to cut prices.
- Since the loan repayment cost is dependent on sales, forecasting monthly cash requirements to repay the loan accurately is challenging. This makes accurately predicting profits more difficult.
What Business Model Makes This Option Possible?
Recurring revenue is usually associated with a subscription model. Here are a few examples:
- SaaS software: There is usually a monthly base payment plus a variable price based on the number of users, the features they can use, and the number of transactions they process
- Equipment as a Service (EaaS): In this model, the product is a robot, jet engine, or wind-powered turbine and is not sold to the customer but is leased with appropriate performance guarantees. The lessor pays the owner a fixed price per unit of outcome or use.
- You may sell products to manufacturers who then incorporate them into their products. They make a shipment of these products every day, and you also deliver more to them every day. Your business is operating a recurring revenue model with some month-to-month variation, but you have historical data to establish a monthly income stream.
- And finally, one of the most reliable revenue streams results from service contracts sold along with your product. Here is an example of one of the oldest and best-known recurring revenue generators, GE Aviation. On February 3, 2022, the daily GE Brief reported an order for jet engines for the new Qatar Airways Boeing 777X:The total value of the order is more than $6.8 billion list price and includes 30 GE9X engines and spares, a new order of four GE90-115B engines for 777 aircraft, and a services agreement to cover the maintenance, repair, and overhaul (MRO) of the engines.The GE 2021 8-K reported:
For the year, revenues of $21.3 billion declined 3% reported and organically* due to fewer Commercial Engine deliveries. Segment margin of 13.5% expanded nearly 800 basis points reported and organically*, driven by a 10% increase in Commercial Services shop visits as well as operational cost reduction.
Consider revenue-based financing if your business needs cash and has strong recurring revenue streams. Service contracts and “as a Service” equipment placements are also potent sources of recurring revenue.
For another perspective on recurring revenue, tap here.
After I had written this post, a friend told me about a company called Pipe. When I looked at their website, I felt compelled to share this with you and talk briefly about the company. First, the Pipe value proposition:
Pipe transforms recurring revenue into up-front capital for growth without dilution or restrictive debt.
Their website tells their story well; if you are interested in this subject, you should look.
To read more about recurring revenue, read Recurring Revenue Could Be Your Business’ Key to Securing Sales.
About Middlesex Consulting
At Middlesex Consulting, we partner with the field service teams of B2B capital equipment companies challenged to grow their top and bottom lines. We use value creation, services marketing, and customer experience techniques to identify and create service offers that achieve customers’ desired business outcomes. To discuss how we can grow your business write to Sam here.