11 Dec Non-Dilutive Funding Showdown: Revenue-Based Financing or Venture Debt
When you found a new enterprise, you can feel like a sheriff in the wild west protecting your ownership. And just like an old-time lawman, you need the right tools to navigate the constant tug-of-war between fueling growth and preserving control.
As increasingly popular alternatives to adding investors, revenue-based financing (RBF) and venture debt can allow you to raise the funds your business needs to grow. The key is understanding which funding tool fits your business needs. After all, Wyatt Earp wouldn’t use a knife in a gunfight or a rifle to free hostages.
This showdown between RBF and venture debt pits the advantages and trade-offs of the two non-dilutive financing products against each other. So when the dust settles, you know which fits your company’s revenue model, growth trajectory, tolerance for risk, and long-term vision.
The Mechanics of Revenue-Based Financing
Revenue-based financing is an advance on your future income. Lenders typically require six months to one year of business history to qualify. When approved, you borrow a lump sum and repay the lender a percentage of your revenue each month until you’ve paid the owed amount.
Suppose your subscription-based SaaS company pulls in $100,000 monthly revenue. You take out an RBF loan for $300,000 with a 1.5 repayment cap. The lender multiplies the borrowed capital by the multiple to set the total repayment amount at $450,000.
Instead of fixed payments, you might send your provider 10% of your monthly income. If your revenue is steady, you will pay off the loan in 45 months in $10,000 increments, though that amount adjusts to your rising or dipping sales.
Venture Debt’s Structure
Early-stage startups that’ve already raised capital through equity financing can secure additional funds with venture debt. It’s the non-dilutive complement to venture capital. Private funders usually require warrants, covenants, board observer rights, or some form of collateral attached to the obligation. Otherwise, venture debt is like a term loan or business line of credit.
Imagine you raised $5 million during the Series A round for your transportation startup in Illinois. A private credit lender for SMEs in Chicago offers an additional $1.5 million with a 36-month repayment term as venture debt. Your loan comes with a 10% annual interest rate after you use your physical assets to secure the loan. This financing extends your runway so you can invest in new hires and fund product development without an immediate equity raise.
The Non-Dilutive Financing Showdown
Revenue-based financing and venture debt offer very different options to small businesses to secure more capital while protecting their equity. Let’s break down the key differences and discover which works best for your business.
Providers
Many alternative lenders offer revenue-based financing. Some only provide revenue-based loans, while others include them in their financial toolbelt with other products. You can look online for reputable RBF providers focusing on your region and industry and offering competitive rates.
Venture debt lenders may be tied to venture capital firms, private credit funds, or specialty banks. Access to these providers usually relies on your VC relationships, and they typically require board observer rights and extensive financial reporting before providing financing.
Qualifications
RBF lenders care about your revenue streams, which means you need enough time in business to show sales patterns. Many lenders require at least six months of operations, and then offer financing to companies with less-than-perfect credit and minimal assets.
On the other hand, venture debt lenders place more weight on your VC relationships and strong financials. They usually offer additional capital attached to a recent equity funding round if you also have a 12-month runway and compelling growth and revenue projections for the coming year.
Ownership
RBF poses no risk to your equity, while venture debt might have a small impact on your ownership if your venture debt lender requires warrants.
Also, venture debt usually only funds VC-backed startups and ties to equity financing rounds. Revenue-based financing is available to bootstrapped, lightly funded, or venture capital startups and businesses in future growth stages.
Funding Speed
Revenue-based financing is relatively quick, while venture debt requires more time. Owners can apply for and secure funds with RBF in a few business days. Founders using venture debt typically access capital within three to eight business weeks.
Loan Amounts
As an advance on your future revenue, lenders tend to offer amounts comparable to your average monthly income. For example, if your media creation firm regularly pulls in $5,000 monthly, you could secure between $15,000 and $40,000 in a revenue-based loan. Companies with strong financials and a steady sales history can plan for greater financing.
Venture debt providers typically offer loan amounts in the millions of dollars, often a corresponding 20-35% of your latest equity funding round. So the more money venture capitalists invest in your company, the more venture debt you can secure.
Repayment Structure
RBF is a flexible repayment structure because you pay about 2-12% of your monthly income for the loan. So, the payment amount increases if your sales increase or decreases if your revenue dips. You make payments until you’ve repaid the total amount owed, usually in 12 to 36 months.
Conversely, venture debt lenders structured repayment like a traditional loan. Providers set the loan term in the agreement, and you make fixed monthly payments over the life of the loan. Standard term lengths range from one to four years.
Cost of Capital
Revenue-based financing typically has a higher capital cost than venture debt because it calculates the total owed amount using a repayment cap rather than an interest rate and loan term.
Consider the borrowing costs for $1 million using venture debt and revenue-based financing. You’ll pay $1,500,000 for RBF with a 1.5 repayment cap, but with a 10% annual interest rate and a three-year term, you would pay about $1,150,000 with a venture debt loan.
RBF is the better option if you want to know the exact cost of capital when you sign the agreement. Borrowing costs for venture capital loans vary depending on the type of interest rate, value of the warrants, fees or penalties, and prepayment options.
Terms and Conditions
All financing agreements set guidelines for using funds, incurring penalties, changing terms, and reporting data. With both options, you usually can’t use the capital to pay off other loans and face limits on taking on new debt.
However, you face significantly more complicated and restrictive conditions with venture debt than with revenue-based financing. Providers typically set performance benchmarks, restrict the capital uses, require extensive financial reports, and include legal distress clauses.
Risk Exposure
The risk of defaulting on revenue-based financing is very low. You have plenty of freedom within the loan terms, and payments adjust to your income. The most significant risk is taking on a high monthly percentage that chokes your cash flow.
Venture debt’s fixed payments and restrictive covenants increase your risk of defaulting, which usually means forfeiting collateral or triggering acceleration clauses. Venture debt can quickly become a liability if you fail to understand the terms and plan for repayment.
The Right Tool for You
The biggest draw with RBF is its flexibility. It aligns with your cash flow, and approval doesn’t require extensive investor connections or underwriting, though it does come with higher borrowing costs.
Venture debt is attractive when you want to smooth out cash flow between capital injections, especially if you’re already on the VC path. It can offer low interest rates and high funding amounts to preserve your equity between rounds if you can handle the increased risk and longer funding times.
There’s no one-size-fits-all answer. You might even use both funding products. If your VC-backed company generates substantial monthly revenue, you could combine a small venture debt loan with RBF. The hybrid approach could extend your runway, reduce borrowing costs, minimize risk, and increase your negotiating power with investors.
When you understand the trade-offs between revenue-based financing and venture debt, you can decide which financing best supports your vision. And like the end of an old western movie, you can use your trusty tools to stop the bad guys, save the day, and ride off into the sunset in search of greater success.