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Is Revenue-Based Financing The Right Option For Your Start-Up

This model is best suited for companies that have demonstrated steady growth but require capital for further expansion

Is Revenue-Based Financing The Right Option For Your Start-Up
POSTED ON September 15, 2023 12:50 PM

In 2021, the global revenue-based financing market size was valued at $901.41 million, according to a report published by Allied Market Research. This sector is expected to grow at a compound annual growth rate of 61.8% from 2020 to 2027. By 2027, it is estimated to touch $42,349.44 million in value. 

Revenue-based finance, which is also referred to as royalty-based financing, is an alternative fundraising model to the equity-based venture capital investment or angel investing model.

Instead of offering equity, founders offer investors a percentage of the company's gross revenues or an opportunity to earn royalties on sales in exchange for funds.

But that does not mean it is the financial holy grail for all start-ups. Founders should evaluate the pros and cons of revenue-based finances and how they compare to debt-based and equity-based models before considering it. 

The Basics Of Revenue-Based Financing 

Companies should generate a certain amount of revenue to qualify for revenue-based financing. Hence, this model is not accessible to pre-revenue early-stage start-ups. 

In this model, companies do not need to give away any equity from their company. Investors offer funds in exchange for a pre-determined percentage, which usually falls between 4 per cent to 10 per cent, of the revenues earned by the start-up.

Typically, there is no set maturity since a company's revenues can vary from quarter to quarter. However, there may be a flexible time frame, which can range from four months to five years. 

The monthly payout to investors is dependent upon the revenue generated. Hence, if revenues dip, the company is not stuck with an unaffordable monthly payment. 

In revenue-based financing, there is always the potential to raise more funds once the initial contract reaches maturity. 

Revenue-Based Vs. Debt-Financing Vs. Equity-Based Funding 

Start-ups require funding at various stages and can access it via diverse models based on their applicability. Sometimes, founders may need to opt for a hybrid model with various components. 

For instance, a founder may go for a mix of debt and revenue-based funding. Hence, it is important to understand the basics of two other popular funding models work.

1. Debt-Financing

In this model, an investor will extend a credit line to the company. The interest and payment tenure will be pre-fixed, akin to a business loan. It comes with certain advantages over a traditional business loan, such as quicker access and a principal amount of higher ticket size.

However, founders will need to offer some form of personal guarantee. For instance, they may use personal assets, such as a house, as collateral. 

They will also need to pay a fixed amount every month. Defaults on payment can come with financial penalties. 

2. Equity-Based Funding  

In this model, founders offer an equity stake in the company in exchange for a large chunk of funding. This is a popular model, especially for those start-ups that require an investment of a higher ticket size and have not started generating any revenue as yet.

Venture capitalists tend to bet on the start-up idea and demand some ownership and higher returns in exchange for the risk they are undertaking.  

3. Revenue-Based Financing 

The start-up world is seeing a spurt in the adoption of revenue-based financing. There are several reasons for this trend. 

One of the key advantages of this funding model is that the risk is lower for founders as compared to equity-based funding, where the stakes are much higher. In such a scenario, investors expect returns to the tune of 10X to 20X. Comparatively, revenue-based financing works out to be relatively cheaper. 

Another key advantage is that the ownership of the business, autonomy, and decision-making stay with the founders. On the other hand, once venture capital investors come into the equation, founders must be ready for higher scrutiny on the running of the business.

In the case of revenue-based financing, investors are satisfied as long as they receive their share of the revenues. They do not occupy board seats or bring in fresh financial demands.

Making The Right Selection 

The revenue-based finance model is applicable to companies that have demonstrated steady growth but require capital for further expansion.

The founders may not wish to part with equity or take a loan. However, generating considerable revenue puts them in a position to access this option. 

Fundraising contracts play a significant role in the business's ownership, sustainability, and profitability.  Hence, making the right funding choice is a critical decision for start-ups—one they must take after a lot of deliberation and weighing the pros and cons of all options. 

-    Jitesh Agarwal, founder of Treelife

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