With such a huge wave of low-cost capital over the last decade, and an influx of new players into the venture ecosystem, many venture capital firms will admit that their market became dysfunctional with compressed due diligence, extremely risky investments, and an appetite for deals at almost any price...

Focusing solely on the US venture market, the latest investment frenzy has far surpassed the dot-com era of the late 1990s, when annual investment reached $100 billion in the US. According to Venture Monitor, American tech companies last year raised a staggering $330 billion, more than double the amount of the previous year 2020.

After the intoxicating years of free money during which the venture capital industry bought a one-way valuation ticket to Crazytown, investment firms are now focused on a restructuring workout across their venture portfolios to the detriment of new deals. And while venture capital is a rarified form of investment in the best of times, the reality now is that investment rates continue to trend downwards which will leave many startups and scaleups struggling to find investment.

Since the start of the year, an increasing number of founders have come to Déjà Partners to ask us about alternatives to venture capital investment. There are several reasons why some founders might be looking for an alternative.

Some founders might be looking for an alternative because they have been rejected by venture capital firms as their business is not in the right industry or stage.

Others might be looking for an alternative because they are not interested in taking on venture capitalists as investors and want more control of their company.

And some may be looking for an alternative because they want to build a company that is employee-owned and don’t want to give up any ownership stake.

However, based on our conversations with founders this year, the primary driver for seeking an alternative to venture capital financing is due to constraints in the funding market resulting in fewer deals and prolonged investment processes.

In the article below, written by the team at Déjà Partners, we explore a flexible alternative to the traditional venture capital model called Revenue-based Financing (RBF). This type of investment provides capital to a business by “selling” an ongoing percentage of a company’s future revenues to the investor.

The RBF model is beneficial for both parties because it gives founders the opportunity to grow without giving up any equity and it provides investors with a return without the company having to achieve an exit.

So, let’s dive in and explore the pros and cons of this funding model.

What is RBF?

Instead of a typical bank loan which requires a business to pay a fixed interest payment, RBF is a type of financial capital provided to small or growing businesses in which investors loan capital in return for a fixed percentage of ongoing gross revenues, with repayment based on business revenues, typically measured as either daily revenue or monthly revenue.

Given the typical ebbs and flows of a business or seasonality factors, RBF payments automatically ramp up or down along with the business. This repayment flexibility is one of the most appealing features of the offering and converts what are typically fixed expenses into variable expenses that are completely in lockstep with a company’s revenue.

While RBF can provide significant advantages and flexibility to businesses, there are two distinct requirements that must be in place for a company to qualify for this form of financing:

  • The first requirement is that the company is already generating revenue and preferably recurring revenue from business models such as eCommerce or SaaS; and
  • The second requirement is that there are strong gross margins so that a business can cope with the percentage of the revenue dedicated to loan repayments.

Using RBF for Invoice Factoring

RBF comes in several flavours. In the first instance, RBF can be used as a form of invoice factoring whereby invoices are uploaded to the RBF provider for near immediate payment net a fee per invoice. This can make a profound and positive contribution to a company’s working capital by minimising the risk of slow debtors adversely impacting the cashflow. Most of the RBF providers that have recently entered the market fall into this category.

Using RBF for Longer-term Growth

In the second instance, RBF is used to fund the longer-term growth of a business. This is where RBF becomes interesting.

In return for an RBF loan, the company agrees to pay a percentage of its future revenue. The advantage here is that a typical RBF provider will have no compounding interest, no hidden fees, no credit checks, no requirement for personal guarantees or security, no board control, no covenants, no valuation requirement and will not take any of your company’s equity. What’s not to like?

In addition, the application process is concluded in a matter of days with the capital following very quickly if the company is successful. This compares favourably to a typical venture capital engagement with a duration of 3-6 months that completely distracts management from operating the business.  

This form of financing is truly non-dilutive if the company cannot or does not want to use venture capital or other equity instruments as its funding source. However, RBF loans can also be used by companies that are already funded by venture capital to manage working capital, minimise equity dilution or to extend the funding runway to the next milestone or valuation inflection point.

Cost of Capital

The cost of capital is an important consideration for founders raising money. Usually, the cost of capital in an RBF loan is significantly less than a similar equity investment, for several reasons:

  • First, the actual interest rate on the RBF loan is much lower than the effective interest rate required by a venture capital firm on their invested capital if the business should be ultimately sold;
  • Second, the legal fees for a venture capital funding round can be large whereas the legal fees for an RBF loan are much lower or near non-existent; and
  • Third, because the investment is a loan, the interest payments can often be a tax deduction for the business.
  • The savings in the cost of capital is a result of the RBF model and nature of the risk taken by the RBF provider. Because the loan is making repayment each month, the RBF provider does not require the eventual sale of the business to earn a return. This means that they can afford to take on lower returns in exchange for the knowledge that the loan will begin to repay far sooner than if it depended on the eventual sale of the business.

RBF is often more expensive than bank financing given that there is no requirement for personal guarantees and no recourse for the RBF provider, in the event of a default, to pursue personal assets.

How exactly does RBF work?

RBF is primarily suited to companies who have a business model that consists of recurring revenue – think SaaS, eCommerce, subscription or transaction vendors. Most RBF providers require a company to have Monthly Recurring Revenue (MRR) of at least €15,000 with a gross margin above 50% to be deemed eligible.

While recurring revenue enables a company to repay RBF loan installments, it is also the basis on which the RBF providers calculate the terms of their loan offer. Most RBF providers will provide companies with a simple integration API so as to access the company’s online store account (e.g. Shopify, Amazon) or their payment platform. Typically, the RBF provider will then use proprietary algorithms to generate a custom loan offer for the company based on the trailing 6 months of revenue or payment data.

A typical RBF loan offer will include the upfront loan amount available to the company and the company’s repayment as a percentage of their daily or monthly revenue until the upfront loan has been repaid. You can expect the RBF provider to take between 10% and 20% of your daily sales for loan repayment and between 5% to 15% in fees. Please note that some RBF providers do not charge fees as instead they use a ‘capped’ strategy where a company repays the loan as well as a cap of the original loan that was provided e.g. 2X the original loan.

RBF is attracting Big Investment

The number of RBF providers has grown substantially in Europe in recent years. According to Sifted, 18 RBF providers have started up in Europe since 2019. And this figure does not include the large North American RBF providers, such as Pipe and Capchase, who have also established themselves in Europe. Note: Clearco shutdown their European operations in August 2022.

Sifted has also created an interesting graph of the amount of capital raised by the RBF providers who are active in Europe:

In conclusion, the team at Déjà Partners believe that the RBF loan model provides founders with an additional choice on how to fund their businesses in these difficult times, not only for working capital management but also for funding longer-term growth. When used alone or in combination with venture capital, RBF also allows founders to either retain their equity or to minimise the dilution of their equity by using debt instead of expensive equity investment.

Thank you for reading!

How We Help Entrepreneurs

At Déjà Partners, we’re passionate about helping the best entrepreneurs and early stage companies succeed. We can work closely with you on a pro bono basis (at no cost) by providing mentorship, guidance, and support in order to get your new business started and be ready to rise to the challenge of building that ‘special’ something from scratch. We can then help you prepare for a successful fundraising with institutional investors or debt providers. And over the longer-term, we are here to help navigate the challenges of scaling your business to create value and achieve your goals. Given our long careers in building businesses – “been there, done that” – we can help you mitigate against the prospect of failure so that you can approach your business journey with growing confidence and optimism.

Contact us today to learn more about how we can help.