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Revenue-based financing allows businesses to use their future business revenue to get financing from investors or financing firms. An alternative to debt or equity financing, revenue-based loans can be good for startup businesses or businesses that don’t qualify for financing through traditional means.
What is revenue-based financing?
Revenue-based financing, also known as revenue-based lending, royalty-based financing or revenue-based investing, is a type of small-business lending that involves an initial investment from a financing company or equity firm. Then, investors receive a percentage of the business’s monthly revenue on an ongoing basis.
It differs from debt financing in that there is no fixed monthly payment. And unlike equity financing, the borrower doesn’t have to trade any percentage of ownership for capital.
Revenue-based loans can be less risky for startup businesses or businesses that are struggling with cash flow, because they don’t require a fixed monthly payment. Rather, your monthly payment is a percentage of your cash receipts, or the revenue you generate.
» MORE: What is equity crowdfunding?
How Much Do You Need?
How does revenue-based financing work?
After deciding on an initial investment amount, the lender will determine the repayment cap. A repayment cap is similar to a factor rate and is used instead of interest on a revenue-based loan to calculate the total repayment amount. A repayment cap can vary by company, but usually falls between 0.4 and 2.0. Your total repayment amount is calculated by multiplying the initial investment amount by the repayment cap. For example, if your initial investment amount is $100,000 and your repayment cap is determined to be 1.1, your total repayment amount would be $110,000 (110,000 x 1.1).
Next, the company may decide on a fixed percentage of the business’s monthly revenue that must be repaid each month — usually 1%-3% of the monthly revenue, but it may be higher in some cases. This means that the amount of each monthly payment will vary because it is dependent on the amount of revenue your business brings in. To determine the percentage, lenders may look at the amount of revenue that the business is likely to generate each month, as well as the expenses they need to cover.
Because the amount of the payment each month can vary, revenue-based loans often don’t have a set end date or term; however, some companies may offer terms, similar to traditional loans. For example, Founders First Capital Partners, a financial services company that specializes in revenue-based lending, offers revenue-based financing with two- to five-year terms.
Who should get revenue-based financing?
Revenue-based financing is usually best suited for high-growth businesses; certain startups; existing businesses that are experiencing cash flow problems but still maintain high revenue; and borrowers who cannot qualify for traditional financing because of poor personal credit. You don’t necessarily need to be turning a profit, have collateral or strong personal financials to qualify for revenue-based financing.
Revenue-based loans rely on immediate revenue, so if you are in a pre-revenue stage of business, it won’t be an option for you. Businesses that aren't yet generating revenue might be better off with a business line of credit or another startup loan option.
Pros and cons of revenue-based financing
Revenue-based loans are accessible to more types of businesses and business owners. Because revenue-based loans are underwritten to the future revenue of a business, they don't rely on business cash flow, personal assets or personal credit. That typically makes them more accessible for businesses and business owners who don’t qualify for traditional financing.
Flexible with business’s month-to-month revenue. With a revenue-based loan, you pay a percentage of the revenue you generated for that month, which allows the payments to be flexible with your monthly business cash flow.
Business owners don’t have to trade ownership for capital. Unlike equity financing, revenue-based lenders don’t take any shares in exchange for providing capital. This allows a business owner to retain full ownership control of their business.
They can be more expensive than traditional loans. Be wary of the repayment cap, and compare it with interest rates on traditional loans if you can. Using our earlier example of a typical repayment cap of 1.1 on a $100,000 loan, consider a traditional loan of the same amount with a 6% fixed interest rate. For that loan, your total repayment amount would be $106,000.
They can be risky if you have high monthly expenses. Monthly payments on a revenue-based loan can eat into your monthly cash. If your business has high monthly expenses, even if you also have high revenue, you may be better off with a loan that will give you a fixed monthly payment.
Revenue is required. This may sound obvious, but it bears repeating — revenue, usually a good amount of it, is required for a revenue-based loan. Because you are repaying a small percentage of that monthly revenue, a lender likely wants to see a certain minimum amount of monthly revenue. For example, Founders First Capital Partners requires a monthly revenue of $1 million or higher, and Flow Capital wants to see at least $4 million.
Alternatives to revenue-based loans
Depending on your type of business, and especially if you’re not a startup, invoice financing may be a better option. Invoice financing works in a similar way to revenue-based lending, in that you are guaranteeing your loan against future invoices. These types of loans work well with seasonal businesses that have sporadic cash needs and cash flow, though they are mostly limited to B2B businesses since repayment relies on invoices rather than general revenue.
If your need is for startup financing, you may want to look at other startup loan options before choosing a revenue-based loan. If you have strong personal financials and collateral, a startup loan with a bank or online lender may be faster, easier and cheaper.
Business line of credit
If you want flexible repayment options, you may also want to consider a business line of credit. Business lines of credit function like credit cards, in that they are revolving and you only pay interest on the amount of money drawn. As soon as you pay back what you borrowed, you can borrow again. Lines of credit can be solid options for short-term cash flow needs, and for startups in certain situations.
SBA loans can be another good option for businesses that are struggling to qualify for a traditional business bank loan. The Small Business Administration doesn't issue loans itself, but rather guarantees a portion of a loan facilitated by various lenders, meaning the SBA will back the loan in the event of a default. That means SBA lenders are more likely to lend to riskier businesses, or business owners that have poor personal credit or finances.
Find the right business loan
The best business loan is generally the one with the lowest rates and most ideal terms. But other factors — like time to fund and your business’s qualifications — can help determine which option you should choose. NerdWallet recommends comparing small-business loans to find the right fit for your business.