What Is Revenue-Based Financing and Is It Right for Your Small Business?

Entrepreneurs have many options to consider when seeking funds to support growth. One of these options is revenue-based financing (RBF). This approach to funding offers small business owners a flexible form of financing without the traditional constraints of debt financing or venture capital.

But what exactly is revenue-based financing, and is it the right fit for your business? Let’s explore the ins and outs of this financing option so you can make an informed decision.

What is revenue-based financing?

Revenue-based financing is a financing model where lenders provide capital to businesses in exchange for a percentage of future revenue. Revenue-based financing is sometimes referred to as royalty-based financing.

Unlike traditional loans, there is no fixed interest rate or repayment schedule. Instead, repayments are tied to the monthly revenue generated by the business, making it a more flexible solution for startups or companies with fluctuating cash flow.

For small business owners, especially those in the early stages, RBF can be an appealing option. It offers growth capital without giving up equity or facing the risk of hefty monthly payments. The business repays the lender through a share of its future gross revenue, which means the repayment amount decreases during slow months, providing a buffer against financial strain.

How does revenue-based financing work?

The mechanics of revenue-based financing are relatively straightforward. Once a business enters into an RBF agreement with a lender, it receives an upfront cash infusion. In return, the business agrees to pay the lender a predetermined percentage of its monthly revenue back until a specified repayment cap is reached.

This repayment cap is usually set as a multiple of the initial investment, typically ranging from 1.3x to 3x. For example, if a business receives $100,000 in financing with a 1.5x repayment cap, it would repay $150,000 over time.

Repayment is directly linked to the business’s performance. During high-revenue months, the repayment amount will be higher, allowing the business to clear its obligations faster. During slow months, when the company’s revenue is lower, the repayment amount decreases.

When may revenue-based financing be a good idea?

Revenue-based financing can be a wise choice for certain types of businesses and specific situations, such as:

Rapidly growing businesses. Companies experiencing rapid revenue growth may find revenue-based funding appealing due to its scalability. The more the business earns, the quicker the loan can be repaid.

Seasonal businesses. Businesses with fluctuating revenues, such as those in the tourism or retail sectors, can benefit from the adaptability of a revenue-based loan, as repayment adjusts with sales.

Business owners avoiding equity dilution. For entrepreneurs who want to retain full ownership and control of their business, RBF provides a non-dilutive financing option.

Early-stage startups. Startups that are not yet eligible for traditional bank loans or venture capital (VC funding) can use RBF as a stepping stone to build their creditworthiness and financial track record. Subscription-based and SaaS companies typically fall into this category.

Revenue-Based Financing vs. Business Loans

When considering revenue-based financing, it’s essential to weigh your options against traditional business loans.

Pros of Revenue-Based Financing

Flexible repayments. Unlike some traditional debt repayment, RBF repayments fluctuate depending on the revenue earned. This approach helps ease financial pressure, especially during months when income is lower.

Non-dilutive. Businesses retain full ownership of their company, because there’s no equity involved in the agreement. Furthermore, personal guarantees are not required. This aspect of RBF is attractive to entrepreneurs who want to maintain control over their business and avoid personal financial risk.

Profitability not required. Your business can still qualify for RBF even if it isn’t currently turning a profit. By focusing on your revenue and growth potential, you can access the funding you need to fuel your business’s success, regardless of your current profit status.

Cons of Revenue-Based Financing

Higher cost. The total repayment amount can be higher than conventional loans due to the repayment cap. Since the repayment cap is a flat fee, your cost of capital doesn’t change, even if you pay off the loan early.

Limited availability. Not all businesses may qualify for RBF, especially those without consistent revenue streams.

High revenue needed. Since RBF lenders receive a small portion of a company’s revenue, they’ll want the company’s monthly revenue to be significant. Your business needs to have a high amount of revenue to qualify for a revenue-based loan.

Pros of Business Loans

Lower interest rates. Traditional loans often come with lower interest rates compared to RBF repayment caps.

Predictable payments. Fixed monthly payments can make budgeting easier for businesses.

Wider availability. Many financial institutions offer business loans.

Cons of Business Loans

Rigid repayment terms. Fixed payments are required regardless of revenue fluctuations, which can strain cashflow.

Collateral requirements. Many business loans require collateral, posing a risk to business assets.

Lengthy approval process. Securing a business loan can be a time-consuming process if you apply for one through a traditional bank or the SBA.

Alternatives to Revenue-Based Financing

While RBF offers a compelling funding option, it’s not the only way to secure funding for your small business. Consider these alternatives:

Term loan. A business term loan is a traditional small business loan. They provide a lump sum of capital with predetermined repayment terms. Term loans are suitable for businesses with steady revenue and a solid financial history.

Line of credit. A business line of credit offers flexibility, allowing businesses to draw funds as needed and repay them with interest. It’s an excellent short-term option for managing cash flow and handling unexpected expenses.

Invoice factoring. Invoice factoring involves selling outstanding invoices to a third party at a discount in exchange for immediate cash. It’s typically an option that businesses with unpaid invoices and slow-paying clients may consider.

Merchant cash advance. A merchant cash advance provides upfront capital in exchange for a percentage of future credit card sales. A benefit of merchant cash advances is that they’re typically easy to qualify for. However, they can come at a high cost.

Equity financing. This involves selling a portion of the business’s ownership to investors in exchange for capital. While it dilutes ownership, it brings in funds without the need for repayment.

Investors. Seeking investment from angel investors or venture capitalists can provide significant funding and valuable expertise. However, it often involves giving up equity and decision-making control.

Crowdfunding. Crowdfunding platforms allow businesses to raise funds from a large number of people, typically in exchange for rewards or early access to products. It’s a creative way of raising capital that requires engagement with your audience.

The Bottom Line

Revenue-based financing presents a dynamic and adaptable solution for small businesses seeking capital without the constraints of traditional loans. Its flexibility in aligning with monthly revenue makes it an attractive option for startups, seasonal businesses and entrepreneurs looking to avoid equity dilution.

However, it’s crucial to weigh the pros and cons carefully and consider alternatives like business loans and lines of credit.

Ultimately, the choice between revenue-based financing and other options depends on your business’s unique needs, growth trajectory and financial health. By exploring the possibilities and consulting with financial advisors, you can make an informed decision that sets your business on a path to success.