While 77% of small business owners either did not need additional credit to stay in business or were able to obtain all that they needed this past year, 20% who have borrowed and now owe money have struggled to find much-needed funds, according to a recent Wells Fargo/Gallup Small Business Index poll. Whether it’s to make running their day-to-day operations easier or expanding their product/service portfolio, hiring employees or just making payroll, being able to borrow money for a number of small business owners seems to be at a bit of a premium these days.
Enter revenue-based financing, a relatively new approach to borrowing and lending that is a cross between a traditional bank loan and tapping into venture capital. According to the recently formed Revenue Capital Association, which now comprises about a hundred lending groups, the basic set-up goes something like this: A firm (or firms) invests in an established business or startup, and the business pays it (or them) back in accordance with its monthly earnings. It’s a great pay-as-you-go option for businesses that are passed over by venture capitalists or angel investors and do not want or qualify for a traditional bank loan.
On the face of it, this arrangement may seem fairly straightforward and simple, but the truth is that it is as nuanced and complex as any other lending option out there. In other words, revenue-based financing comes with its own pluses and minuses, making it the perfect fit for some small business owners and not so much for others.
As is true of most things, understanding the potential pros and cons is what allows a small business owner to know if the idea of revenue-based financing is worth pursuing. So here’s a quick overview:
The pros of revenue-based financing:
• Oftentimes faster and less painful than more traditional lending options
• No conflict over valuation
• Focuses more on revenue models, business situations and cycles throughout the year than it does on personal history or FICO scores
• Investors look for a good or great product or service as opposed to a given company or team
• Does not require a business owner to give up his/her equity in the company
• Offers more payment flexibility given it is variable and pegged directly to revenue
• Payback amounts are limited (or capped)
• Does not require a track record of profitability, rather funds are awarded on a prospective as opposed to a retrospective basis
• Does not require a personal guarantee of assets, such as real estate, a home or other possessions, so borrowers only risk losing what’s left of their business should things go badly
• Very favorable option for seasonal businesses that have predictable bursts of cash flow
The cons of revenue-based financing:
• Much riskier than a traditional bank loan
• Usually does require an applicant background check of some kind
• Returns vary, but are almost always higher that a typical bank loan, making this option a relatively expensive one
• Borrower pays a pre-set percentage of revenue until the principal is paid off, plus a return, which can be as high as 18 to 20 percent or more
• Having to pay investors back as a set percentage of profits can severely limit the small business owner’s ability to reinvest necessary capital in their company, which can in turn stall growth or even result in failure
• Delinquency of payment after a set time period results in the borrower losing everything―their business, patents, domain names, trademarks, etc.
While the revenue-based model is particularly gaining traction among startups, there have been many instances where relatively young and promising companies have also benefited from this fairly new financing approach. It’s just one more example of how the free-market system evolves to meet the demands of an ever-changing marketplace, and many small business owners are grateful to have yet one more option to get the funding they so desperately need, especially when all other doors have closed.