Revenue-based financing (RBF), also known as royalty-based financing, is a unique form of financing provided by RBF investors to small- to mid-sized businesses in exchange for an agreed-upon percentage of business’ gross revenues.
The capital provider receives monthly payments until his invested capital is repaid, along with a multiple of that invested capital.
Investment funds that provide this unique form of financing are known as RBF funds.
– The monthly payments are referred to as royalty payments.
– The percentage of revenue paid by the business to the capital provider is referred to as the royalty rate.
– The multiple of invested capital paid by the business to the capital provider is referred to as a cap.
Most RBF capital providers seek a 20% to 25% return on their investment.
Let’s use a straightforward example: If a business receives $1M from an RBF capital provider, it is expected to repay $200,000 to $250,000 per year to the capital provider. That amounts to about $17,000 to $21,000 paid per month by the business to the investor.
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As such, the capital provider expects to receive the invested capital back within 4 to 5 years.
Each capital provider determines its own expected royalty rate. In our simple example above, we can work backward to determine the rate.
Let’s assume that the business produces $5M in gross revenues per year. As indicated above, they received $1M from the capital provider. They are paying $200,000 back to the investor each year.
The royalty rate in this example is $200,000/$5M = 4%
The royalty payments are proportional to the top line of the business. Everything else being equal, the higher the business’s revenues, the higher the monthly royalty payments the business makes to the capital provider.
Traditional debt consists of fixed payments. Therefore, the RBF scenario seems unfair. In a way, the business owners are being punished for their hard work and success in growing the business.
To remedy this problem, most royalty financing agreements incorporate a variable royalty rate schedule. In this way, the higher the revenues, the lower the royalty rate applied.
The exact sliding scale schedule is negotiated between the parties involved and clearly outlined in the term sheet and contract.
Every business, especially technology businesses that grow very quickly, will eventually outgrow their need for this form of financing.
As the business balance sheet and income statement become stronger, the business will move up the financing ladder and attract more traditional financing solution providers. The business may become eligible for the traditional debt at cheaper interest rates.
As such, every revenue-based financing agreement outlines how a business can buy-down or buy-out the capital provider.
The business owner always has an option to buy down a portion of the royalty agreement. The specific terms for a buy-down option vary for each transaction.
Generally, the capital provider expects to receive a certain specific percentage (or multiple) of its invested capital before the business owner can exercise the buy-down option.
The business owner can exercise the option by making a single payment or multiple lump-sum payments to the capital provider. The payment buys down a certain percentage of the royalty agreement. A proportional percentage will then reduce the invested capital and monthly royalty payments.
In some cases, the business may decide to buy out and extinguish the entire royalty financing agreement.
This often occurs when the business is being sold, and the acquirer chooses not to continue the financing arrangement. Or when the business has become strong enough to access cheaper financing sources and wants to restructure itself financially.
In this scenario, the business has the option to buy out the entire royalty agreement for a predetermined multiple of the aggregate invested capital. This multiple is commonly referred to as a cap. The specific terms for a buy-out option vary for each transaction.
There are generally no restrictions on how a business can use RBF capital. Unlike in a traditional debt arrangement, there are little to no restrictive debt covenants on how the business can use the funds.
The capital provider allows the business managers to use the funds as they see fit to grow the business.
Many technology businesses use RBF funds to acquire other businesses to ramp up their growth. RBF capital providers encourage this growth because it increases the revenues that their royalty rate can be applied to.
As the business grows by acquisition, the RBF fund receives higher royalty payments and benefits from the growth. As such, RBF funding can be a great source of acquisition financing for a technology company.
No assets, No personal guarantees, No traditional debt:
Technology businesses are unique because they rarely have traditional hard assets like real estate, machinery, or equipment. Technology companies are driven by intellectual capital and intellectual property.
These intangible IP assets are difficult to value. As such, traditional lenders give them little to no value. This makes it extremely difficult for small- to mid-sized technology companies to access traditional financing.