According to the U.S. Bureau of Labor, there are 27.9 million small businesses in the United States. Acquiring financing to start up or expand your company can sometimes be difficult, some banks and financing companies can be reluctant to lend without a personal guarantee for a loan.
Perhaps your credit score is less than perfect. Your start-up may be too small or in a sector that does not interest venture capitalist, who expect big returns on their investments. So how can you secure enough capital together to get your business off the ground?
Revenue-based financing is not a new concept. In the past is has been used to finance gas, oil and mineral extraction.
Financiers made investments in the companies in exchange for a percentage of the operations’ earnings. This method has improved with age and more recently it has been used to fund bio-tech and pharmaceutical companies.
Basically, it is comprised of a fixed repayment loan that is paid off over several years. The repayment amount is set at a percentage of your monthly revenue.
Repayment schedules can be flexible so you can pay them off sooner if you can, and later if you are having some difficulties, which means you’re less likely to default on the loan. This form of financing means you retain full control of your company and do not have to sell equity.
If you have already established your business and wish to expand, or buy new equipment, revenue-based financing is the best way to grow your company without accruing massive debt.
For example, let’s say you need to buy some powder coating equipment, such as this at Reliant Finishing Systems, but you don’t have the capital to pay for the equipment, a revenue-based loan can solve this problem for you.
If you are considering a revenue-based loan, it’s important that you fully understand your company’s profit margins. You should have a gross profit margin of 15%-25%. Gross profit is your revenue less the cost of production of the goods sold, expressed as a percentage of total revenue.
Benefits of Revenue-based Financing
- The application process is easy and financing is usually given within a month.
- There are no fixed payments; instead, the repayments will fluctuate along with your monthly revenue.
- Your loan will be repaid completely when you have accrued enough gross revenue to pay it off.
- Revenue-based loans are non-dilutive so you won’t lose stakes in your company.
- No formal valuation of your company is required.
- Revenue-based financing does not require an exit-strategy.
- You do not have to guarantee the loan with your personal assets.
- You can take out this type of loan as you need it, rather than borrowing a large sum at once.
- Loan repayments are usually withdrawn electronically from your business account each month.
How to Quality For a Revenue-based Loan
- You will need a minimum FICO score of 550.
- You must be able to show that your company generates regular revenue.
- You must have a detailed account of how you will use the money for your company.
- You will need a gross margin of 50% to be able to pay for the loan.
- Typically you will need $15,000 per month in revenue.
- Usually you can apply for a loan up to one third of your business’s annual revenue.
The Disadvantages of Revenue-based Financing
One of the biggest drawbacks of this kind of funding is the long-term cost. Over the length of your loan, you will probably be paying back two or even three times the amount you borrowed. So bear in mind you’ll be taking on a lot of excess costs. For example, let’s say you take a $500,000 loan from a bank at an interest rate of 7 percent.
Over five years at this interest rate, you will pay back around $600,000. If you borrow the same amount from a revenue-based lender, you will end up paying back up to $ 1 million.
You are still under obligation if you fail to pay back the loan. Even if your company goes under, the lenders will collect your business assets, which could mean you lose your infrastructure and maybe intellectual property.
Revenue-based financing is not right for everyone.
If your company is already generating revenue, but you don’t have hard assets to help you secure a bank loan, a revenue-based loan could be good for you, particularly if you are confident that you can recoup enough revenue that the payback won’t hit you too hard. It will help you get through seasonal fluctuating revenues while leaving you in full control of your company.
Archie Norman is a business consultant. He works with businesses to better cash flow and finances and provides startups with support.