How to Know if Revenue-Based Financing is Right for Your Startup

In 2021, the global revenue-based financing market size was valued at $901.41 million. This market is expected to grow at a compound annual growth rate of 61.8% from 2020 to 2027. By 2027, it is estimated to touch $42,349.44 million in value.

Revenue-based finance, which is also referred to as royalty-based financing, is an alternative fundraising model to the equity-based venture capital investment or angel investing model.

Instead of offering equity, founders offer investors a percentage of the company’s gross revenues or an opportunity to earn royalties on sales in exchange for funds.

In this blog, we explore the pros and cons of revenue-based finances and how it compares to debt-based and equity-based models.

Revenue-Based Financing: The Basics 

• To qualify for revenue-based financing, companies need to be generating a certain amount of revenue. Hence, this model is not accessible to pre-revenue early-stage startups.
• Companies do not need to give away any equity from their company. Investors offer funds in exchange for a pre-determined percentage (usually between 4 to 10%) of the revenues earned by the company.
• Typically, there is no set maturity since a company’s revenues can vary from quarter to quarter. However, there may be a flexible time frame, which can range from four months to five years.
• The monthly payout to investors is dependent upon the revenue generated. Hence, if revenues dip, the company is not stuck with an unaffordable monthly payment.
• In revenue-based financing, there is always the potential to raise more funds once the initial contract reaches maturity.

Revenue-Based vs. Debt-Financing vs. Equity-Based Funding 

Startups require funding at various stages and may need to access it via diverse models based on their applicability.

Sometimes, startup founders may need to opt for a hybrid model, which can have various components. For instance, a founder may go for a mix of debt and revenue-based funding. Hence, it is important to understand the basics of two other popular funding models work:

1. Debt-Financing

In this model, an investor will extend a credit line to the company. The interest and payment tenure will be pre-fixed, akin to a business loan. It comes with certain advantages over a traditional business loan, such as quicker access and a principal amount of higher ticket size.

However, founders will need to offer some form of personal guarantee. For instance, they may use personal assets, such as a house, as collateral. They will need to pay a fixed amount every month. Defaults on payment can come with financial penalties.

2. Equity-Based Funding  

In this model, founders offer an equity stake in the company in exchange for a large chunk of funding. This is a popular model, especially for those startups that require an investment of a higher ticket size and have not started generating any revenue as yet.

Venture capitalists tend to bet on the startup idea and hence, demand some ownership and higher returns in exchange for the risk they are undertaking.

The Growing Relevance of Revenue-Based Financing 

The startup world is seeing a spurt in the adoption of revenue-based financing. There are several reasons for this trend.

One of the key advantages of revenue-based funding is that the risk is lower for founders as compared to equity-based funding, where the stakes are much higher, and investors expect returns to the tune of 10X to 20X. Hence, revenue-based financing is relatively cheaper.

Another key advantage is that the ownership of the business, autonomy, and decision-making stay with the founders. On the other hand, once venture capital investors come into the equation, founders must be ready for higher scrutiny on the running of the business.

In the case of revenue-based financing, investors are satisfied as long as they receive their share of the revenues. They do not occupy board seats or bring in fresh financial demands.

In Conclusion

The revenue-based finance model is applicable to companies that have demonstrated steady growth but require capital for further expansion.

The founders may not wish to part with equity or take a loan. But generating considerable revenue puts them in a position to access this option. Having said that, making the right funding choice is a critical decision for startups, one that must be taken after weighing the pros and cons of all options.

Fundraising contracts play a significant role in the ownership, sustainability, and profitability of the business.  Hence, it is advisable for startups to partner with a legal and financial firm like Treelife, which comes with the expertise to help them make informed decisions. 

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Treelife provides legal and financial support to startups, small business, companies and entrepreneurs with access to a team of professionals.