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Revenue Based Financing Definition
Revenue based financing is a special type of fundraising for startup businesses from investors or VCs. Also referred to as royalty-based financing, investors in this system of financing usually get back their capital from shares of the gross earnings of the enterprise. Simply put, investors or VCs, whichever is the case, will get paid from the business’s profits till an agreed amount is reached. This amount doesn’t necessarily need to be equivalently or slightly above the original principal, as most investors happen to get up to five multiples of their capital in this system. Payment is generally determined by percentage of profits and not on a fixed price basis. This assists in eliminating the possibility of negative returns in periods of low income.
A Little More on What is Revenue-Based Financing
Revenue-Based Financing, while it is similar to debt financing, is quite different as it has a structure which is a bit more complex. In revenue-based financing, the enterprise which received the capital will have to make regular payments to the investor till the agreed some is completed (usually higher than the initial investment value). Unlike debt financing, revenue-based financing repayments are directly proportional to the performance of the business entity. Thus, if the company records low sales and subsequently low income for a month or period of months, the repayment made to the investor within that duration will also be small. This is mostly because payment is made using the percentage rule, so the lower the income, the lower the repayment. On the other hand, if the income of the business entity increases substantially, or grows enormously during a month or period of months, the repayments made to the investor will be higher than what usually occurs during the period of low or moderate sales or profitability. Revenue-based financing investors can be likened to as lenders, as they hold no share in the company before and even after the investment has been made unlike equity financing investors. Thus, revenue-based financing can be said to be the combination of the different factors of debt financing and equity financing, as it holds most of the features possessed by the two.
Revenue-Based Financing and Revenue Bonds
Revenue-based financing is similar to revenue bonds when comparing their cash flow structure. Most companies or construction contractors will issue revenue bonds to sponsor different projects like establishment of infrastructure instead of using general obligation bonds. An example would be the establishment of a toll road or toll gate. After such a structure is established, typically using the debt financing system, the returns or profits made from that asset will be split according to the agreed percentage and used to repay the investors till the designated repayment amount is met.
Revenue-based financing on the other hand functions similarly to revenue bonds, but it is mostly utilized by small businesses that are unable to get sponsors or traditional financing. Revenue-based financing investors are usually referred to as business partners since they are in the profits of the business, as well as the loss. This is one of the reasons why startup entrepreneurs are happy to partner with them despite the ridiculously high interest paid on the loan over time. Nowadays, it isn’t surprising to see a number of VCs engaging in such financing method rather than via conventional financing strategies, and they’re mostly attracted to the Software as a Service industry (SaaS).