Revenue-Based Financing — where’s the bargain?

The color of the beast:

Revenue-based investing or royalty-based financing (RBF) is a type of financial capital provided to businesses in return for a fixed percentage of ongoing gross revenues, this is why investor’s return on investment is variable over time. We can call it a loan when some kind of principal is paid back to investors after the agreed lapse of time. We call it a royalty when there is no paying back of the principal at all but there are income streams fixed over a lifetime of a project: usually for over a decade, or more. The latter one is especially prevalent in mineral resources, oil and gas. Variable income streams from RBF mark the key difference with traditional loan where we find fixed interest payable at regular intervals. The other key difference with traditional loan is that in case of RBF only future business revenues are pledged to investor community, while there is usually no requirements for any collateral or pledge out of existing business assets or personal assets of the business owner to secure the loan.

The floating RBF returns on investment resemble of variable returns on equity over time. However, revenue-based investing is not equity: it does not imply any ownership nor any control of the business under RBF financing.

RBF lies somewhere in-between traditional interest-based loan and equity: it is for sure a hybrid beast.

The Price Tag:

RBF is more expensive than traditional loan but much less expensive then equity financing or venture capital financing. RBF also spares other constraints associated with venture capital participation, such as more or less important loss of control of the business, voting rights, mandatory board of directors representation, expensive valuation exercise. A short recap on where RBF sits between the two:

Where’s the gravy?

That’s a straightforward one. Whatever happens, a bank loan interest is always due. Of note, during the latest COVID-19 restrictions, the loan interest was due in all jurisdictions that we know of. No force-majeure excuses there. If there was lack of cash inflows (and there most certainly was for a majority of businesses), look at what happens:

Business revenues vs traditional bank loan service

There is a shortfall of cash to cover loan payments, and we haven’t yet counted any other payouts like salaries and rent. More often than not, after missing several payouts on traditional loan there is an insolvency procedure, and the borrower’s collateral is sold at a fire sale to salvage whatever the lender can make of it. This is the very reason why collaterals are usually priced much lower than the usual market value at the inception of the loan. This add further constraints on business owner and unwinds the downward spiral. Founders know this.

Now, let’s look at RBF under the angle of COVID-19 black swan event. As revenues fall down, so do the RBF liabilities. On the top of it, there is no collateral looming over the founder’s head to be disposed of (collateral, that is).

Business revenues vs. RBF liabilities

There is no cash shortfall as RBF liabilities are commensurate with the revenues. For that reason, the payback period can be extended because of unfavorable circumstances. I have seen RBF being called “patient capital” which it indeed is when times are bad. This is also the reason why RBF is more expensive than the traditional bank loans are. But, as the borrower and the lender both benefit from the growth of the business, their interests are aligned. We would even describe RBF as founder-friendly capital. Let’s look at what happens with RBF in normal times when the business grows as intended:

Growth phase — business revenues vs. RBF liabilities

It is not very visible on the graph as RBF rate represents only 5% of revenues in our example, therefore we don’t even see a dent in our graph, but if we look at a graph of RBF payouts only, we see that in one year RBF investors’ revenue grew more than fourfold. RBF is friendly to lenders too! Investing in traditional debt financing wouldn’t let the lender take part in the business expansion.

RBF payouts during business expansion phase

Next, we will look where RBF came from and how it is used now…

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