Revenue Base Funding - an Overview

On April 28, Michael Kaplan with Revenue Capital Management (RCM) http://revcapfunds.com/ talked about revenue based funding at OTBC.  These are my notes from the presentation.  Of course, any errors or omissions are mine!

The basic idea in revenue based capital is that instead of selling ownership in your company, you sell rights to a percentage of your company's revenue for some period of time.  This is a funding approach that has been commonly used in the past for movies.  Today, it's becoming more common for a broader set of companies because exits are tougher. 

Instead of offering an investor a big exit, it offers smaller liquidity, but liquidity that happens sooner.  

RCM will provide funding as large as 5% to 25% of a company's annual revenue.  Payment is made monthly, and is equal to 3% to 10% of monthly revenues, and payments keep getting made up to some cap.  The cap level depends on the risk but is typically from 2x to 5x the amount that was financed. 

What types of companies are a good fit for revenue based funding?  It is more expensive than debt, so it is likely to be attractive to companies who, for whatever reason, do not have access to debt financing.  And a company must have current revenue to qualify, so early-stage, pre-revenue companies don't qualify.

So is this simply a loan, with a very high interest level, or is it more comparable to an equity investment?  Michael argues that it is more like an investment.  When you borrow money from a bank, you commit to repayment and you commit to a specific rate of repayment.  Revenue funding, on the other hand, is a variable payment.  The guarantee you make is that you pay a percent of revenue.  But if revenue goes down, your payment goes down.

Another difference compared to a bank: lenders want a promise + collateral.  If the company violates its covenants then it may forfeit the collateral - and be out of business.  Revenue based financing typically has no collateral requirement and no operating covenants. Because of that, revenue based funding is riskier than a bank loan, and that is one of the reasons that it is more expensive than bank debt. 

Why would a business consider this as a source of funding instead of equity or debt?  Michaels comment was "if you can get bank debt, do it.  It will be less expensive."  But there are times when bank debt is not available.  Here are the other advantages of revenue based financing that Michael discussed:

• - He argues that revenue financing is cheaper than equity because there's a cap on what you pay.  If you sell equity in your company, there is no cap on what you will pay because there is no limit on how valuable that equity will become. 
• - While revenue based funding is more expensive than debt, it has fewer constraints.  There are, for example, no covenants - as long as you keep up the percent-of-revenue payments.
• - This type of funding is available for growth capital;  bank debt rarely is available to finance growth.
• - There is no ownership dilution.  The founders retain 100% ownership
• - There is no valuation negotiation - only a negotiation of what percent of revenue will be paid each month, and what the total cap on payment will be.
• - No loss of control. The revenue funding entity does not purchase stock, and does not get a board seat.
• - No hockey-stick expectation on returns - just the regular payment of a percent of revenue
• - No personal guarantees are required of the founders - unlike the typical bank loan scenario
• - No restrictive convenants - unlike bank loans
• - Variable payments (depending on revenue) as opposed to the fixed payment typically required by a bank loan
• - No collateral - you simply keep paying the percentage of revenue until the cap is reached.
• - When you reach the cap, it's over.  No loss of equity - and you start keeping 100% of revenue.

Situations where revenue capital fits:

• - Lifestyle business that generates cash.  These are typically not fundable by investors (they don't provide sufficient returns)
• - Ownership transfers (owner wants to turn business over - but wants some up front cash)
• - A growing business for which equity may be too expensive and they may not qualify for a bank loan
• - A company whose investors are suffering from "VC fatigue" - can't get the next round done

An actual example of a deal negotiated by RCM:

• - 4 year old service business
• - Grew in tough years of 2008 to 1010    $1.4  to $1.7M in revenue
• - Needed $450K to finish new product and fund some marketing
• - Expected this would double revenue in 3 years
• - Banks: required balloon note and $450,000 dollar deposit;  but why  borrow $450K if they needed to deposit that much?
• - They came up with $200,000 themselves, and needed to finance the remaining $250,000 
• - The deal: monthly payment of 5%  of revenue with a 2.5x cap  

So how does a revenue based funding company make sure they get paid?  For a start, they do due diligence, much like an investor would do.  They also require bank access rights (access to deposits).  And while there are no general covenants, there are guarantees around compliance.  If a company earns revenue or has the right to earn revenue, but does not pay the required monthly percentage then there are some heavy consequences - like losing control of the company.  But the idea is that it's totally under the company's control.  If revenue goes down, the payment is reduced. 

Revenue based funding typically subordinates to existing positions (bank debt).  Revenue based funding companies are willing to do this because they are betting on the sustainability of the business.  Having revenue funding can make the balance sheet better, which is a good thing from a banks point of view, so there are situations where even the bank will look positively on revenue based funding.  On the other hand, revenue based funding can create problems with existing bank covenants, so it does not always fit when there is already bank debt in place.  Other times, the bank can be OK with having revenue funding in place as long as they get their money first.

How much can RCM fund?  RCM will typically finance from $250K to $800K, and they can syndicate to finance larger deals.  Since they will finance from 5% to 25% of annual revenues and will work with companies that have at least $2 million in annual revenue. 

Their model is based on 5 year pay-back.  If it happens faster, they make a higher ROI.  But it may happen slower - or not at all.

That's a quick summary.  If you company has revenue but does not have access to bank debt, revenue based funding is certainly an option worth exploring.