Revenue-Based Finance: truly different, but when is it better?

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.

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About rlucas
Current entrepreneur and investor at RevenueLoan, doing growth financing for small businesses. Formerly with VC firm Voyager Capital in Seattle, startup Tercent, Inc. in Portland, and a variety of tomfoolery in Boston, MA (primarily skipping classes at Harvard to go down the river to MIT).

7 Responses to Revenue-Based Finance: truly different, but when is it better?

  1. Pingback: Angel Investing: Components of Royalty Based Investment Model | Venture Hype

  2. JaneR says:

    I’m curious. I suppose it can all be boiled down to actual dollars and sense. It seems that the end cost to the borrower might be a whole lot more than a typical loan? Or am I wrong?

    • rlucas says:

      JaneR, thanks for the comment. I like your phrasing of “dollars and sense.”

      If everything goes right for the business, an RBF investment will usually cost more than debt, both in terms of an effective interest rate and total paid. That’s the “dollars.”

      But if the business hits a speed bump, then the inherent flexibility of an RBF could allow the business to survive, where it might have been crushed under the weight of an amortizing traditional debt payment. That’s the “sense.”

      Think of it like the extra cost and weight of adding air bags and ABS to a car. In a theoretical perfect race car lap, it just slows things down and costs more. But in the “real world,” the first near-miss that ABS lets you walk away from more than pays for itself.

      (Finally, it’s worth noting that RBF doesn’t always have to cost more than amortizing debt, even on a theoretical, flat cost-of-capital basis; that’s one for a different post, though.)

  3. MarkC says:

    How is RBF reflected on the balance sheet and income statement say for the following RBF structure: $50K investment, 2% royalty on gross margin payable quarterly, annual cap at $30K, lifetime cap at $300K.

    • rlucas says:

      Mark, good question. It depends on the way it’s “papered.” Most RBF investors I know of, like Lighter Capital, use a “debt-like” structure in which case it’s carried as long-term debt on the B/S and allocated to interest expense on the P&L.

      Some investors use a preferred-stock based buyback or dividend approach, which would of course be in equity on the B/S and post-tax on P&L.

      Still others use a royalty/IP licensing scheme that stays off-balance sheet but comes out contra gross income on the P&L.

  4. venturedebt says:

    This is a thoughtful post and stream of questions. I’m looking forward to seeing how this evolves over time. BTW, cost doesn’t equal the lender’s IRR or an implicit interest rate – that’s looking at it from the lender’s perspective. The only way to calculate the cost of a debt deal is to look at an exit analysis with the debt and without. You can sensitize this for several scenarios but you’re not solving for an interest rate, you are solving for the amount of exit proceeds for the stakeholders.

    • rlucas says:

      Tim, I’ll agree and add another — you also want to solve for the risk of financial distress / insolvency. I suspect a bias toward avoiding that is at play in the preference of many entrepreneurs for equity dollars. RBF, or other creative forms of repayment over time, can mitigate that risk.

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