Revenue-Based Finance: truly different, but when is it better?
July 23, 2010 7 Comments
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.