For small business owners trying to expand their business, capital is a necessity. It's difficult to achieve substantial growth without funds to invest in your business. But what happens if you're denied a bank loan or can't find investors?
An option that just might work for entrepreneurs in need of capital is revenue-based financing (RBF). BJ Lackland, CEO of revenue-based financing company Lighter Capital, shared these five important things small business owners should understand about RBF.
1. It's a loan, but not like one you would get at a bank
"Revenue-based financing is unique because it provides entrepreneurs with growth capital in return for the financer being paid a small percentage of future revenues. It’s technically a loan, but there are no fixed payments, no set time period for repayment, and no set interest rate," Lackland said.
RBF works by having business owners pay a fixed percentage of their revenue, so payments are directly related to how much revenue the company makes. Lackland explained that the loan is fully repaid when payments reach the "repayment cap" — a number that is set when the loan is funded. The repayment cap is typically equal to 1.5 to 2.5 times the principal amount. According to Lackland, most RBF lenders expect the repayment cap to be met in about four to five years, but how long it takes depends entirely on the growth and performance of the company.
2. It aligns the entrepreneur's success with the investor's success
While revenue-based financing investors don't own shares or sit on the board of the company they invest in, RBF is similar to equity in that it's in the investor's best interest for the business to grow quickly and successfully, Lackland said. Why is that? According to Lackland, if the company grows more quickly than expected, the investor receives the repayment cap more quickly than expected — perhaps in three years instead of five years. This greatly increases the investor’s return on investment (ROI). [6 Questions All Business Investors Want Answered ]
"RBF investors have every incentive to help the company grow, either through bringing sales opportunities, or additional financing or helpful advice," Lackland said.
3. It’s more expensive than bank loans, less expensive than equity
According to Lackland, a bank will charge you around 6 to 9 percent interest, plus fees, whereas equity investors are generally looking for about 10 times their investment. While bank loans are less expensive and low-risk, they're often difficult for small business owners to obtain. Equity investments, on the other hand, are all about high risk and high return.
"Revenue-based financing sits in the middle, more expensive than a bank and less expensive than equity," Lackland said, adding that RBF investors typically target an annual return of 15 to 30 percent.
4. It's not for every small business
"Businesses with low gross margins are not well-suited for this financing model because the investors are being paid a percentage of revenue, effectively compressing gross margins even more," Lackland explained, adding that a better fit for revenue-based financing are businesses with high gross margins, due to their scalable nature. According to Lackland, having high gross margins allows for significant increases in cash flow from growth, even while the business is paying back the investor a percentage of revenue.
5. It isn’t a new concept
"Revenue-based financing was actually very popular in the early-to-mid 1900s, especially in the oil and gas industries, where it was common to provide large sums of cash upfront in exchange for a percentage of the royalties generated," Lackland said. Lackland also added that the RBF model is still commonplace in the movie, music, publishing and pharmaceutical industries.