The manner in which startup companies obtain their financing can have a very large impact on the future of their business. In the previous articles, we have already discussed how bootstrapping as well as investments by professional investors work. Both of these approaches have their own advantages and disadvantages. Up until recently, it was assumed that these are the only two alternatives for a startup firm to raise money. However, with the passage of time, we have realized that this is not necessarily the case.

It is possible for startup firms to obtain financing using a third method which is called revenue-based financing. In this article, we will have a closer look at what revenue-based financing is as well as how it affects investors as well as the founders.

What is Revenue-Based Financing?

Revenue-based financing is a method in which an entrepreneur can approach professional investors in order to raise funds but they can do so without giving up a portion of their equity. In traditional investments, investors obtain an equity stake when they invest in a company.

In revenue-based financing, investors are not provided with equity stakes. Instead, investors are entitled to receive a part of the revenue of the firm for a specified period of time. Hence, an investor can invest $10 million in a firm in return for 5% of the revenues of the firm. Additionally, the startup company may have to return a multiple of the original investment at the end of the period. For example, the company may have to pay 1.25× of the original investment in order to compensate the investor for undertaking the risk.

Advantages of Revenue Based Financing

The concept of revenue-based financing is quite recent. However, it has been growing at a very rapid pace. This is because of certain advantages which are associated with revenue-based financing.

1. Higher Rate of Return: Firstly, revenue-based financing is preferred by venture capitalists and angel investors because it allows them to generate a higher rate of return as compared to debt investments. The returns are not as high as their equity investments but then the risks are also much less.

   Professional investors have come up with different versions of revenue-based financing. Shared earnings agreement and point of sale capital are some versions that have become quite popular. There has been a considerable rise in the number of companies and investors using revenue-based financing and this is expected to continue in the near future.

2. No Need to Liquidate: A major issue faced by many venture capitalists is the lack of a well-defined exit strategy. In many cases, finding a different investor or going for an IPO can be impractical. Hence, when investors invest their money in startups, they assume a certain amount of exit risk. In the case of revenue-based financing, no external event is required for the investors to exit the transaction. The exit will be facilitated by the revenue generated by the firm.

3. No Dilution of Equity: From the owner’s point of view, the best feature of revenue-based financing is that they do not have to give up their equity stake. Also, they do not have to take on additional leverage in the form of debt financing. The revenue-based financing model works perfectly for investors as they can temporarily obtain financing without losing permanent equity in their firm.

Disadvantages of Revenue-Based Financing?

Even though revenue-based financing has been growing by leaps and bounds because of the above-mentioned, there are several disadvantages of this model. Some of these have been discussed below:

1. Does Not Work for All Companies: Revenue-based financing does not work for all kinds of startup firms. Firstly, it does not work for startup firms if they are not at the stage where they generate revenue. Also, this model does not work for firms whose revenue cycle is erratic. Revenue-based financing is only useful for firms whose revenue model can be predicted reasonably. This is not the case with many startups which excludes them from this financing model.

2. Conflict with Debt Financing: Revenue-based financing assumes that the startup company will pay the investor a percentage of the revenue. This works fine till the startup company has enough capital to pay the investors as well as the debt holders. However, in case there is a shortage of revenue, both the investors and debt holders will believe that they have the first claim on the available revenue. This could end up in a legal tussle. In order to avoid such a situation, the agreement between should clearly state how the cash flow issues will be resolved.

3. Lack of Data: Lastly, since revenue-based financing is a very recent phenomenon, there is a significant lack of data. Investors and companies are still making educated guesses about the final results of similar deals which have taken place in the past. The absence of such deals can be quite catastrophic for the investors.

The bottom line is that revenue-based financing is a relatively recent mechanism that is being used in order to raise funds. However, the effects of this arrangement are not fully known and hence its advantages and disadvantages cannot be fully known for sure.