Revenue-Based Financing: Non-Dilutive(!) Risk Capital

By: Paul A. Jones

At a first cut, the start-up world consists of two broad categories: small business start-ups and high impact start-ups. The former are typically boot-strapped to the point where they can access traditional credit facilities to finance modest growth – vehicles that give the investor a fixed payment schedule rather than an equity interest. High impact startups generally need outside risk capital investors, typically venture capitalists who are looking for “uncapped” returns through an equity interest – returns they can eventually realize by selling their equity stake in an “exit” transaction. Between these two paradigms there are a number of structures that “mix and match” the features of the traditional debt and equity paradigms. One such alternative is so-called revenue-based financing. While the opportunities where revenue-based financing makes in the high impact start-up universe are relatively rare, if you are an entrepreneur with one of those opportunities, a revenue-based financing structure can be very appealing.

Revenue-based financing: The basics. Revenue-based financing, often called “revenue royalty certificate” financing, involves an investor providing capital to a business in exchange for the business’ promise to pay the investor a percentage of future revenues. The “royalty” percentage is usually based on gross revenues, and the return is usually based on a multiple of the investment. A simple example would be a deal in which the entrepreneur agrees to pay the investor 5% of gross revenues until the investor has received an amount equal to 3 times the capital provided by the investor. A common tweak to the model (I suspect you can think of many more) would incorporate a rate of return element into the deal by making the return multiple vary depending on how long it takes to achieve it.

Revenue-based financing: The appeal. If you look past the details, the essence of a revenue royalty certificate financing looks a lot like a traditional equity-based venture financing deal: the company gets some risk capital (i.e. capital that there is no obligation to repay in the eventuality that future revenues are not sufficient to repay it), and the investor gets the opportunity for a nice risk-adjusted return (the return target, whether a simple multiple of capital or a time-adjusted multiple of capital, is typically significantly greater than the interest rate for a traditional loan). The attraction, then, of revenue-based financing is in the details. For the entrepreneur, the appeal is not having to give up any equity (ownership) in the business to the investor – and no related obligation to create a market for the business’ equity. For the investor, the appeal is the assurance of a return (assuming there are revenues, of course) whether or not there is ever a market for the company’s equity. The investor’s return is not as a practical matter tied to the entrepreneur having an obligation to sell the business to a third party or create a public market for the business’ equity.

Revenue-based financing: The candidate start-up profile. Alas, while the appeal of revenue-based financing is real, the range of high impact start-up situations where it makes sense is fairly narrow. Clearly, it rarely applies to a start-up that can access sufficient capital from more traditional non-dilutive funds sources, for example banks. Traditional business lenders will almost always be cheaper, in terms of the returns they seek, than risk capital investors who by definition are looking for equity-like returns. On the other hand, revenue-based financing will generally not work for risk capital investors where the risks (technical, market, execution) are extensive, which is to say the kind of start-ups that are typically most attractive to venture capital investors and venture-like angel investors. It is over the middle ground – start-ups with more risk and upside than the typical bankable company, but less risk and upside than the typical venture capital candidate – where revenue-based financing can find a home. More particularly, whether or not it might otherwise be appealing to the entrepreneur, the revenue-based financing model can be a viable alternative for a startup with some combination of the following attributes: Good near-term revenue visibility, high gross margins, well-defined capital needs and, as often as not, limited scaling potential; situations where there is more risk than a traditional lender would accept, but less risk (and likely less upside) than a traditional venture investor expects to take. Looked at from the other side of the table, it will generally not make sense where the technical, market, or execution risk make the likelihood of significant (relative to the payout hurdles of the revenue-based financing deal) high margin revenues commencing within 12-24 months problematic. So, for an obvious example, forget pre-clinical drug discovery and development start-ups.

Revenue-based financing: A caveat. As I’ve noted in past blogs, venture capital investors and similar risk capital investors typically make investments based more on the quality of the team than either the market opportunity or technology. They go to great (and often controversial) lengths to make sure the team doesn’t pre-maturely exit the deal, thus, founder and employee vesting schedules for equity, co-sale rights, etc. Those kinds of “golden handcuffs,” particularly vesting, are problematic in revenue-based financing structures. Revenue-based financing investors should be careful about making sure the entrepreneur is really committed to see the startup through to the point where either the investor has achieved the agreed upon return or the business can be successfully managed by a new team.

Revenue-based financing: Conclusion. Some combination of technical, market, and execution risk, often further complicated by uncertain capital requirements, make most high impact start-ups poor candidates for revenue-based financing structures. But for the occasional high impact start-up in the revenue-based financing sweet spot in terms of those risks, particularly those with well-defined capital requirements and limited scaling potential, revenue-based financing is worth a hard look.


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