RBF Central

Satirical country singers “Bretton Wood” and “Merle Hazard” have a real hit on their hands with “Inflation or Deflation:”

Their chorus, chilling in some ways if funny in others, is:

Inflation or deflation?
Tell me, if you can
Will we become Zimbabwe
Or will we be Japan?
Credit markets came undone
And still are in distress
Will the dollars in my mattress
Buy much more next year or less?

If you knew which of the two were just around the corner (and no consensus seems firm today), how might you invest?  Well, the usual answer looks like this:

Deflation:

• Each dollar increases in value.
• Generally considered the “third rail” of modern economies.
• Debt securities (fixed coupon) become more valuable…
• … if the debtor can still make its payments!
• … Hence, Treasuries are the order of they day (as long as the Marines have ammo, they’re legal tender).
• Equity securities theoretically deflate nominally…
• … but the stresses of debt and falling prices might sink companies.
• … Hence, stocks get a double-whammy.
• A central bank can fight deflation by “printing money” (q.v. “Helicopter Ben”).

Inflation:

• Each dollar decreases in value.
• A little bit (say, 1-10%) is par for the course, if unpleasant.
• So-called “hyperinflation” (over 25% a year, extended) renders traditional accounting unreliable.
• Debt securities become far less valuable.
• Equity securities should be relatively OK, if businesses can pass on inflationary cost pressure along with their prices.
• A central bank can fight inflation by raising rates in a “hawkish” manner (q.v. “Paul Volcker”).

Revenue-based financing investments are somewhat different in character.  They have some debt-like characteristics (required, though floating, payments, and usually a fixed total return cap), and some equity-like characteristics (higher overall return, indexed to the company’s revenues).  How might an RBF investment perform under deflation or inflation?

Deflation:

• Company’s revenue drops with general prices.
• Hence, RBF payment streams drop.
• However, the RBF total cap stays in place, so the total return, over time, is fixed (but it happens over a much longer period).
• The company is not exposed to the “deflationary trap” of fixed debt service.
• The investor “eats” the timing risk, but gets the same number of (ultimately more valuable) dollars eventually.

Inflation:

• Company’s revenue increases with general prices.
• Hence, RBF payment due increases.
• However, repayment is capped at the RBF cap, so company is “off the hook” earlier than expected.
• Investor receives fixed amount of (less valuable) dollars, but should receive them much faster.

(Note that all the above is generally applicable, in reverse, from the company’s perspective.  So inflation is good for the debtor, just as it is bad for the traditional creditor.)

Your comments are welcome, gentle reader, but I submit that the RBF model helps cushion the blow either way, as opposed to the very inflexible debt or the rather volatile debt model.

How much does revenue capital cost?  In other words, how expensive is revenue-based financing (RBF) as a source of venture funding compared to equity and traditional loans?

Rather than vaulting into financial engineering, Greek equations and Modigliani-Miller debates, consider the following first-hand account:[i] Read more of this post

The United States has a problem: entrepreneurs and venture capitalists are having trouble getting funded.  Less than 1% of startups attract equity-based venture capital in the US.  Making matters worse, the US venture capital industry posted negative 10-year returns as of 2010, with a 31% decline in first quarter dollars raised by VC firms (compared with the first quarter of 2009).  Times are hard.

What about other countries?  Does the US have it better?  Worse?  How do venture capital environments compare in BRIC nations, and how can revenue-based finance help?

Read more of this post

Revenue-Based Finance (RBF) is a model for funding businesses by “selling” a percentage of future revenues.

RBF is unlike debt, which typically is repaid on a strict schedule with fixed payments, and unlike equity, which is a “residual” claim usually only realized (for small, private companies) when a company is sold or wound down.  RBF investments pay off more quickly than equity (good for the investor) but are more inherently flexible than debt, because the payments required float up and down with revenue levels (good for the entrepreneur).

So, the model is different: in theory, then, for certain types of businesses and certain situations, RBF should be better than debt or equity.  (Conversely, debt or equity may well be better in other situations.)  What are the cases where Revenue-Based Finance really shines?  Well, we can look at historical evidence:

• Extractive industries (e.g. Oil & Gas) have used a royalty structure for a long time.
• Broadway musicals typically use a multi-tiered royalty structure.
• Movie production has shifted to a revenue-based model for some interests.
• Healthcare businesses (especially device and pharma) have used RBF heavily in recent years.

One conversation I had with a finance professor suggested that the key indicator for RBF suitability is “marginal margin.”  That is, not merely what the average (net) margin is on the income statement, but what the margin will be on the incremental dollar of revenue generated by using the new funds.  When does your marginal margin increase?

• When you’ve got positive economies of scale.
• When R&D or exploration costs up front have to be amortized over a long exploitation period.
• When you have a “viral loop” in the business.

On the other hand, you can wind up with decreasing marginal margin as well; for example, if you’ve exploited all the “low-hanging fruit,” you’ve saturated a market, or you have diseconomies of scale (perhaps temporary, like a large “step function” in your production costs).

I get the sense that the academic and research world has left RBF as an orphan (the efforts of Thomas Thurston notwithstanding), and that there’s plenty left here to explore.  However, we may have to learn from the empirical results of folks applying the model today, before the theoretical underpinnings get figured out.