Revenue-Based Options: When to Use Them, When to Avoid Them
- 6 days ago
- 6 min read
Revenue-based financing (RBF) has gained traction in recent years, particularly among app founders and finance leaders looking for alternative funding structures. This innovative financing option allows businesses to secure upfront capital in exchange for a percentage of their revenue.
Understanding when to utilize RBF—and when to steer clear—can make a significant difference in your company's financial health. This post will explore the benefits and drawbacks of revenue-share financing for apps with early Monthly Recurring Revenue (MRR), discuss covenant discipline, and implement scenario planning, providing you with practical insights to enhance your financing strategy.
What is Revenue-Based Financing?
RBF is a flexible financing solution tailored for growing companies. When you opt for RBF, you receive immediate capital that you repay as a percentage of your monthly revenue. Repayment continues until you reach a predetermined cap, which typically ranges between 1.3× to 1.8× the advance amount. This model allows your payments to align with your revenue performance: during lean months, you pay less, while in better months, you can accelerate repayment.
To clarify, here are some key terms related to RBF:
Advance Size: Often tied to a multiple of your current MRR or eligible revenue.
Take Rate: This can range from 4% to 12% of your monthly gross receipts.
Cap / Multiple: For instance, if you receive a capital advance of $150,000 at a cap of 1.5×, you'd end up repaying $225,000.
Term Guardrails: These include maximum payment duration and minimum monthly payment thresholds.
For founders and finance leads, understanding these terms is imperative for navigating RBF agreements effectively.
When Revenue-Based Financing Fits
While RBF is attractive, it isn't a one-size-fits-all solution. Here are scenarios where RBF clearly fits—green lights for your financing journey.
Early, Real MRR with Visibility
One of the strongest indicators that RBF might be suitable is having early yet stable MRR. If you have six to twelve months of receipts, consistent churn rates, and predictable cash flows, RBF could be a viable option.
Gross Margins of 60%-70% or More
Having healthy gross margins means you can afford to share a portion of your revenue without jeopardizing your operational capabilities. If your company gross margin exceeds 60%-70%, you have the bandwidth to distribute a percentage of your earnings while still covering costs of goods sold (COGS) and funding growth.
Short Payback Loops
RBF works best when your marketing and product development cycles yield swift revenue increases. If your business experiences minimal seasonal fluctuations, you can pay back your advance more quickly, making RBF an attractive option.
Debt-Averse or Equity Dilution-Sensitive
If you want funding without the strings attached to equity issuance or a complicated valuation negotiation, revenue-based financing can present a straightforward alternative. RBF offers a way to fuel your growth without diluting your ownership or taking on traditional debt.
When Revenue-Based Financing Doesn’t Fit
While RBF has many benefits, there are also scenarios that raise red flags.
Lumpy or Enterprise Revenue
If your revenue model relies heavily on significant but irregular enterprise contracts, RBF might not be the best fit. Irregular revenue can lead to erratic payments that complicate the effective Annual Percentage Rate (APR).
High Churn or Negative Net Revenue Retention
Learning from your customer retention metrics is essential. If your churn rate is high or you're experiencing negative net revenue retention, responsible financing will require you to address these issues before adopting RBF. Payments could undercut cash flow, limiting your ability to fix fundamental problems in your business model.
Thin Margins
If your gross margin is below 50%-55%, every percentage point of revenue sharing can negatively impact your businesses' sustainability. Be cautious if your profit margins are low, as repayment obligations can compound challenges.
Hidden Velocity Clauses
Aggressive caps, high take rates, and covenant stipulations regarding no repayment holidays can lead RBF to behave worse than traditional venture debt. It's crucial to read the fine print and ensure you're fully aware of all potential constraints.
Evaluating the Decision with Key Performance Indicators (KPIs)
To make informed financing decisions, monitoring key performance indicators (KPIs) is essential. Here’s a breakdown of five critical KPIs to consider:
Gross Margin (GM%): Aim for ≥ 65% after processor and infrastructure fees.
Net Revenue Retention (NRR): Should be ≥ 100%, with logo churn below 3%-4% per month.
Cash Conversion Cycle: Billing-to-cash cycle should be ≤ 30-45 days.
Monthly Net Burn: Ensure your burn rate post-RBF remains within an acceptable risk budget.
Coverage Ratio: Assess gross profit against (RBF payment + fixed operating expenses). A healthy ratio should be ≥ 1.3× in your base case.
Establishing these metrics will enable your finance team to make strategic decisions about RBF or explore alternative financial options.
Practical Modeling of Payments
Understanding how to model RBF payments is critical for forecasting. Here’s a simple pseudocode to help you visualize the payment structure:
```
Given:
Advance = 150,000
CapMultiple = 1.5
CapAmount = Advance * CapMultiple # 225,000
TakeRate = 0.08 # 8% of monthly revenue
MinPayment = 7,500
MaxTerm = 24 months
Loop months 1..MaxTerm:
Revenue[m] = MRR[m] * 1.00 # or use GAAP revenue if cleaner
Payment[m] = max(Revenue[m] * TakeRate, MinPayment)
CumulativePaid += Payment[m]
if CumulativePaid >= CapAmount: stop
```
This model visualizes the monthly payment schedule and demonstrates how payments reflect your revenue performance.
Sensitivity to Watch
It's important to keep an eye on repayment timelines. If you hit the cap within eight to ten months, you could face an exceptionally high effective APR. Conversely, if you extend repayment past the maximum term, be wary of unknown fees or potential default triggers contained within the covenants.
Understanding Covenant Discipline
Implementing covenant discipline is crucial when considering RBF. It involves the careful examination of the terms and definitions associated with your financing agreement.
Clarifying Key Terms
Ensure that you define terms like "revenue," "eligible receipts," and the differences between gross and net thoroughly. Clarity on these definitions will help prevent misunderstandings and protect your business.
Reporting and Defaults
It's essential to agree on what kind of financial reporting will occur during the term of finance. This can include bank connections and ledger access to maintain transparency. Additionally, understanding the default triggers—such as revenue drops or late reports—is paramount. Be sure to clarify the grace periods and prepayment policies that exist within your agreement.
Scenario Planning for Financial Resilience
Scenario planning is invaluable in navigating RBF applications effectively. Consider conducting a 15-minute drill using three scenarios:
Base Case: Your average growth and churn from the last three months.
Downside: A hypothetical drop in revenue of -50%, churn up +50%, and a couple of flat months.
Upside: One strong month with a revenue increase of +20% to +30%.
For each scenario, compute the following:
Time to cap
Total fees paid
Effective APR
Runway delta (Cash In – Cumulative RBF payments + gross profit gains)
Assess your coverage ratio to ensure it remains ≥ 1.3×.
Understanding these variations will empower your finance leadership to make informed strategic decisions.
When to Look for Other Financing Options
While RBF has its advantages, sometimes it's wise to seek alternative funding sources:
Working Capital Lines: If your invoicing and collections are dependable, secured lines on receivables could be beneficial.
Venture Debt: If you have equity backing and require greater financing support, venture debt may offer a more attractive solution.
Equity Financing: If you are pre-MRR or pursuing a non-linear product, equity financing could be less risky than letting fixed repayments hinder growth momentum.
Crafting Your Financing Ask
When approaching potential RBF lenders, it's essential to have an organized pitch. Here's a template for a one-pager that you can customize:
What You Do: A concise statement summarizing your business.
Revenue Profile: Present your last six to twelve months of performance, including MRR, GM%, churn, and NRR metrics.
Use of Funds: Detail three specific items tied to expected revenue gains.
Repayment Case: Outline the time-to-cap under base, downside, and upside scenarios.
Covenants You Can Tolerate: Specify the types of financial reporting you'd be comfortable with, such as reporting cadence or payment holiday logic.
Supporting Artifacts: Include cohort charts, churn diagnostics, and cash collections history.
Having this document prepared will accelerate your discussions with potential financing partners.
Final Reflections on Financial Health
Navigating the complex landscape of financing options, particularly in the realm of revenue-based financing, requires careful consideration and proactive planning. By understanding the pros and cons and verifying if it aligns with your business needs, you can make confident decisions that promote the health and growth of your organization. Whether you proceed with RBF or seek alternative funding options, remain focused on building sustainable practices that support growth and innovation.
For further insights and tailored financial guidance, consider visiting AD ASIA Consulting.
Comments