John Borchers is the cofounder and Managing Director at Decathlon Capital Partners, a revenue-based financing firm.
As businesses look to finance their next funding rounds to bring about greater company expansion, two instruments have garnered significant attention among entrepreneurs and CFOs alike: revenue-based financing (RBF) and traditional venture debt.
From budding entrepreneurs to seasoned business leaders, many view these two funding mechanisms as interchangeable due to overlaps in application criteria and target companies.
Both are repaid in monthly or quarterly payment structures, and both typically offer flexible use of funds for burgeoning businesses. However, confusion often stems from a lack of deep understanding of their distinct structures and terms. Such misconceptions can lead to suboptimal financing decisions.
In order for companies to find the optimal way to fuel their growth, understanding the nuances between these two options is essential. Making the right choice can both increase the likelihood of a successful fundraising effort and help ensure long-term success.
Understanding The Basics
1. Revenue-Based Financing
Revenue-based financing is centered around its terminology: revenue. Repayment options for a funding round are intertwined with a company’s performance, with debt service payments structured as a percentage of a company’s monthly revenues. If a company sees increased growth, the repayment rate goes up; slower months bring about a decreased amount.
In an RBF arrangement, a growing business obtains essential capital to expand business operations, hire more staff or increase distribution channels. The list goes on for what can be done with an RBF funding round. The repayment is typically structured over three to five years, with payments calculated based on the company’s revenues from the preceding month.
Because revenue is required to garner a revenue-based financing package, this is a deterrent for newer startups just entering the market. Levels of financing may also be lower than what a company could find in a venture debt deal, which is a factor to consider if you are just trying to get your organization off the ground.
Two other features in most RBF funding packages that differ from traditional venture debt offerings are dilution and financial covenants.
2. Venture Debt
Most venture debt packages require a company to provide warrants to the venture debt lender. This means shareholders will experience dilution with venture debt, and the effective cost of venture debt capital is oftentimes more expensive than it first appears. The more successful a company is in creating enterprise value over time, the more costly the venture debt funding becomes.
Often overlooked, venture debt lenders typically require several financial covenants (liquidity ratios, tangible net worth covenants, etc.) as part of their legal structure. While business owners may not initially focus on the financial covenant requirements, the existence of these covenants can restrict both operating and strategic decision-making downstream, leading to under-optimized outcomes.
This can lead to unexpected footfalls that will sometimes allow a venture debt lender to call a technical default on a company and use the default as an excuse to assess penalties. The larger majority of institutional-grade revenue-based funding providers do not require financial covenants. Businesses are free to invest capital in long-term growth without any restrictions or risk of a technical default.
Venture debt has grown in popularity as a funding method for early-stage companies, and I’ve noticed it is especially popular among those who have had successful VC funding rounds in the recent past.
While it may be an appealing option at first glance, there are certain aspects that can make it difficult for some businesses. If a company does not have institutional venture capital sponsorship or its last venture equity round was completed too long ago, venture debt lenders may not be willing to support a company going forward.
Flexibility And Predictability
RBF presents a more dynamic risk-return profile than venture debt. Since repayments align with revenue, both the lender and borrower share in the company’s success or downturns. Not only does this allow greater flexibility for the borrower, but it also creates a closer lender-borrower relationship.
When looking at the underwriting process, flexibility and ease are what make an RBF transaction attractive. In lieu of focusing on other aspects of a company’s economic portfolio—prior venture capital investment, etc.—an RBF underwriting process instead focuses on a company’s revenue potential, historical performance, collateral and market opportunity. This streamlines the review process and allows bootstrapped businesses or non-venture-backed companies to still access financial resources for growth without any dilution or governance requirements.
Venture debt, however, offers fixed payments to lenders, irrespective of how the borrowing company performs. This fixed nature of a company’s payments can provide predictability for both parties but may present challenges for companies if revenues dip significantly. If companies experience a down period while funded via venture debt, there is an increased risk of a liquidity crunch or even default.
Industry Preferences And Economic Influences
RBF once again champions flexibility in its industry preferences, as approval hinges on the business’ historical performance stability, making this model accessible to companies across various sectors. Venture debt, on the other hand, is best suited for high-growth companies and companies in sectors favored by institutional venture investors such as technology, healthcare and communications.
Economic conditions will undeniably influence what financing method to tackle for your business. During periods of economic volatility, the adaptability of RBF becomes a shining attribute. It permits companies to navigate and adapt their financial obligations in sync with fluctuating market conditions.
However, in periods of economic stability and predictable growth, the structured nature of venture debt could be compelling for companies if they can handle the warrant-based dilution and financial covenant restrictions.
Finding The Right Funding Structure For Long-Term Success
Both RBF and venture debt offer alternatives to traditional equity financing, allowing companies to access capital for growth without a valuation event or equity fundraising process. Each has its niche, catering to different needs within the broader business financing landscape.
While venture debt is certainly more appealing than a traditional bank loan, the choice becomes much harder when revenue-based financing enters the conversation. It’s essential for companies to understand the nuances between RBF and traditional venture debt, assess their financial position and choose the route that aligns best with their growth trajectory and financial health.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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