Revenue-based funding: what it is and how it works
If you want to start a business, but don’t have the capital to invest in equipment and initial inventory, revenue-based funding may be the answer to your prayers. In this article, I will explain what revenue-based funding is and how it works.
Revenue-based funding works well with startups that are already generating some form of income through sales or service provision but need additional capital to help them grow and expand their offerings before they can expect profits and repayments from customers.
Is Revenue-based Financing Good?
Revenue based financing has become a popular way to finance a business. The concept is simple: You pay the bills with your revenue, not with cash or working capital. And if your company can’t generate enough income to cover its expenses, you’re free to borrow money from a bank or other lender who will lend you the money against your collateral (the assets in your company that secure the loan).
The benefits of revenue-based financing include:
Lower interest rates. Revenue-based loans usually require lower interest rates than other types of loans because lenders know they won’t have to write off bad debt as quickly; if a customer stops paying his bill, for example, there’s less risk to them when they lend money.
No need for collateral. Since there is no requirement that you offer any type of security (the property or assets that secure a traditional loan), you’ll be able to use your company’s assets as collateral instead which means you won’t have to worry about selling off assets like cars or office furniture before you can repay the loan.
More flexible repayment terms. Since lenders know they’ll only get paid when customers pay their bills, they tend to offer more flexible repayment schedules than traditional lenders do.
How Does revenue-based Funding Work?
For example, let’s say you have an online store and you need revenue-based financing e-Commerce of $100,000 for your inventory. You can find someone who will invest $50,000 in exchange for 40% of your earnings from now on. The investor gets 40% of your earnings (minus any agreed-upon expenses) each year until they’ve received $150,000 back. If it takes you three years to pay off your debt with these agreements in place, the investor receives 10% per year ($50k), while you get back your original investment plus 20%.
Set aside time to set up your agreement: The agreement between you and the investor should be outlined before signing anything. Make sure to discuss what the agreement entails before agreeing to anything!
It might take some time, but it’ll save you more time down the line if things go sour. Negotiate terms as well as deadlines that make sense for both parties; how long does this deal last? Who pays what? etc. Even though all this work may seem like a headache, trust me when I say putting this into place upfront will save you a lot of headaches later on!
How Much Does Revenue-based Financing Cost?
Well, it’s a common misconception that revenue-based financing is free money. It can be confusing for lenders to know how much they’re going to get back on each dollar they put in. Some lenders estimate that their rate of return will be 15% or more.
They do this by charging an up-front fee and a low monthly fee that gradually increases as the borrower reaches their pre-determined revenue goals. For example, they might charge an upfront fee of 5% and a monthly fee of $0.01 at first, then increase the monthly fee to $0.02 after six months and finally to $0.05 after one year if you’ve hit your revenue goal.
Another way people calculate what they’re likely to earn from investing in revenue-based financing is by using something called Internal Rate of Return (IRR). IRR is the percentage earned annually when an investment & future cash flows are discounted back to today’s dollars.
Basically, it’s the annualized effective interest rate given by dividing the present value of all expected cash flows divided by the amount invested today. You can think about IRR like buying stocks: if you invest $1000 now and expect to make 50% next year (or an IRR of 50%), you have essentially bought shares at half price!
If you’re looking for a way to finance your business in Europe that doesn’t involve traditional methods like loans or investors, uncapped revenue-based funding may be a good option for you. This type of financing is becoming increasingly popular, as it allows businesses to grow without giving up equity or taking on debt. While it’s not right for every business, it can be a great way to get the capital you need to get started or expand your operations.