What is income-based financing?
Revenue-based financing [RBF], also known as royalty financing, is a unique form of financing that RBF investors provide to SMEs in exchange for an agreed percentage of total corporate income.
The capital provider pays a monthly amount until his investment capital is repaid and a multiple of the investment capital.
An investment fund that provides this unique form of financing is called an RBF fund.
the term
- Monthly payments are called royalties.
- The percentage of revenue that an enterprise pays to a capital provider is called the royalty rate.
- The multiple of the investment capital paid by the enterprise to the capital provider is called the upper limit.
case study
Most RBF capital providers seek a return on investment of 20% to 25%.
Let's take a very simple example: If a company gets $1 million from an RBF capital provider, the company expects to repay the capital provider $200,000 to $250,000 a year. This is about $17,000 to $21,000 per month for investors.
Therefore, capital providers hope to recover their investment capital within four to five years.
What is the ROYALTY rate?
Each capital provider determines its own expected royalty rate. In the simple example above, we can work backwards to determine the rate.
Let us assume that the company's total annual revenue is $5 million. As mentioned above, they received $1 million from the capital provider. They pay investors $200,000 a year.
The royalty rate in this example is $200,000 / $5M = 4%
Variable ROYALTY rate
The royalties are proportional to the top line of the business. Under the same conditions, the higher the income generated by the enterprise, the higher the monthly royalties paid by the enterprise to the capital provider.
Traditional debt includes fixed payments. Therefore, the RBF scenario seems unfair. To some extent, business owners are punished for their hard work and successful business development.
To solve this problem, most royalties financing agreements include a variable royalty rate table. Thus, the higher the income, the lower the patent rate used.
The exact slip scale is negotiated by the parties involved and is clearly listed in the glossary and contract.
How do companies withdraw from income-based financing arrangements?
Every business, especially technology business, grows rapidly and will eventually exceed their demand for this form of financing.
As business balance sheets and profit and loss tables increase, the business will rise to the financing ladder and attract more attention from traditional financing solution providers. The company may qualify for traditional debt at a lower interest rate.
Therefore, each income-based financing agreement outlines how companies buy or acquire capital providers.
Buy option:
Business owners can always choose to purchase a portion of the royalty agreement. The specific terms of the purchase options for each transaction vary.
Typically, a capital provider expects to obtain a certain percentage [or more] of its investment capital before the business owner exercises a purchase option.
Business owners can exercise options by making a single payment or multiple one-time payments to the capital provider. The payment purchased a certain percentage of the royalty agreement. Investment capital and monthly royalties will be reduced proportionally.
Buyout options:
In some cases, the company may decide to purchase and cancel the entire royalty payment agreement.
This usually occurs when the business is sold and the acquirer chooses not to continue financing arrangements. Or when the business becomes strong enough to get a cheaper source of financing and wants to restructure itself financially.
In this case, the company may choose to purchase the entire royalty agreement to obtain a predetermined multiple of the total investment capital. This multiple is often referred to as the upper limit. The specific terms of the buyout option for each transaction vary.
Use of funds
There are generally no restrictions on how companies use RBF capital. Unlike traditional debt arrangements, there is almost no restrictive debt contract on how companies use funds.
Capital providers allow business managers to use the funds they deem appropriate to grow their business.
Acquisition financing:
Many technology companies use RBF funds to acquire other businesses to increase their growth. RBF capital providers encourage this form of growth as it increases the revenue that its royalties can apply.
As the business grows through acquisitions, RBF funds receive higher royalties and therefore benefit from growth. Therefore, RBF funds can be an important source of technology company acquisition financing.
Benefits of income-based technology company financing
No assets, no personal guarantees, no traditional debt:
The uniqueness of technology business is that they rarely have traditional hard assets such as real estate, machinery or equipment. Technology companies are driven by intellectual capital and intellectual property.
These intangible intellectual property assets are difficult to value. Therefore, traditional lenders have little value. This makes it difficult for small and medium-sized technology companies to obtain traditional financing.
Income-based financing does not require companies to use any asset mortgage financing. Business owners do not need personal guarantees. In traditional bank loans, banks usually require the owner to provide personal guarantees and recover the owner's personal assets in case of default.
The interests of RBF Capital Providers are consistent with the owners:
Technology business can scale faster than traditional services. As a result, revenues can increase rapidly, enabling companies to pay royalties quickly. On the other hand, inferior products that are introduced to the market can quickly disrupt business revenue.
Whether the business grows or shrinks, traditional creditors such as banks receive fixed debt from commercial debtors. In the lean period, companies pay the same debt to the bank.
The interests of RBF Capital Providers are consistent with the owners. If business income is reduced, the funds obtained by RBF capital providers will be reduced. If the business income increases, the capital provider will receive more funds.
Therefore, RBF providers want to grow their business revenue so that they can share upside space. All parties benefit from increased business income.
High gross profit margin:
Most technology companies have higher gross margins than traditional companies. These higher profits make RBF affordable in many different areas of technology.
RBF funds seek high-margin businesses that can easily pay monthly royalties.
No equity, no board seats, no loss of control:
The capital provider shares the success of the business but does not receive any interest in the business. Therefore, the cost of capital in the RBF arrangement is cheaper than comparable equity investments in terms of finance and operations.
RBF Capital Providers are not interested in participating in business management. The extent of their active participation is to review the monthly income reports received from the business management team in order to apply the appropriate RBF royalty rates.
Traditional equity investors want a strong voice in business management. He hopes to have a board seat and a certain degree of control.
Traditional equity investors expect a multiple of their investment capital to be much higher when they sell their business. This is because he rarely receives any financial compensation before selling the business, so the risk is higher.
Capital cost:
RBF Capital Providers receive payments every month. It does not need to sell the business to get a return. This means that RBF capital providers can withstand lower returns. This is why it is cheaper than traditional equity.
On the other hand, RBF is more risky than traditional debt. The bank receives a fixed monthly payment regardless of the financial status of the business. If the company fails, the RBF Capital Provider may lose all of his investment.
On the balance sheet, RBF is located between bank loans and equity. Therefore, RBF is usually more expensive than traditional debt financing, but cheaper than traditional equity.
Funds can be received within 30 to 60 days:
Unlike traditional debt or equity investments, RBF does not require months of due diligence or complex valuations.
Therefore, the turnaround time between providing the business owner with a list of financing terms and funds paid to the business can be as short as 30 to 60 days.
Companies that need immediate funding can benefit from this fast turnaround time.
Orignal From: Revenue-based financing for technology companies without hard assets
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