When NOT To Raise Revenue-Based Financing

Guest Post by Randall Lucas, [email protected]

As an investor with RevenueLoan — the Seattle-based pioneer of Revenue-Based Financing (RBF) for growing businesses — I spend most of my time telling people, in one way or another, how they SHOULD use RBF to finance their businesses.

(Revenue-Based Financing is a way for entrepreneurs to raise money by “selling off” a percentage of revenue, not a percentage of the company. It often can be more attractive than either debt or equity … but I’m biased because it’s my job.)

However, I’m acutely aware that I’ve got a hammer called RBF, and sometimes everything looks like a nail. So, with that in mind, I feel it’s good sometimes to look at the failings and mismatches of RBF, and so I present this list of times when you should NOT raise Revenue-Based Financing.

1. Declining Marginal Margins. If your gross margins are flat to declining with scale — meaning that you make less profit on each incremental dollar of sales — you should run screaming from Revenue-Based Financing.

This would be the case for certain kinds of businesses where you pick the “low-hanging fruit” early, and where the rest of the customers are hard and expensive to reach. Or, where the market is so small and saturated that trying to push more product actually will move prices down.

Why not Revenue-Based financing in this case? Simple. If you owe a financier 10% of your revenue, but your marginal gross margin drops to 10%, you’ll be in a pickle where the optimal thing to do is to stop selling — and that’s a damn weird bind to put an entrepreneur or a company into. “Perverse incentives” kick in at that point — and neither you nor the financier is likely to be happy.

2. One-Way Ticket to Crazytown. If the VC train has left the valuation station — and it’s on a one-way ticket to crazytown — you might find yourself able to raise funds at a premoney valuation that even YOU, the optimistic entrepreneur, don’t believe in.

If that’s true — and it’s definitely been the case in ancient (late ’90s) and arguably in recent (late 2000s) history — then selling off a percentage of your revenues is almost certainly a worse deal for you. After all, the reason why RBF is a win for investors is that it repays on a variable basis, based on revenue collection, making for (usually monthly) cash flow returns.

RBF returns aren’t calculated based on an inflated valuation (or a deflated one, either). So, RBF is probably going to be closer to “fair” value than a stratospheric premoney valuation. And if you’re getting the best of a wildly unfair deal … you probably don’t want to negotiate against yourself.

(That said, it’s not a good idea to shoot for a jacked up valuation for its own sake; the risk of later disappointment with a “down round” is usually too great.)

3. Buying Bonds. OK, so you probably aren’t buying Treasury bonds, exactly — but you might be in need of funding to buy a building, or some other asset that produces a regular and predictable return. A traditional bank should be able to help, and if they can, then don’t you dare call up RevenueLoan or any of our brethren in the RBF world.

Why not? Simple. If the asset produces regular enough returns that a bank can lend against it — then you can bet that LOTS of banks will lend against it, and they’ll implicitly or explicitly be bidding against one another. There’s a market price, and a low bidder — and it’ll almost certainly be cheaper than RBF.

That’s not because RBF is inherently more expensive — it’s not, really — but it’s because a large part of the value of RBF comes from its variable nature. If the asset you’re buying has perfectly predictable returns, you don’t get any benefit from funding it with a variable-payment RBF. You’d rather pay a lower effective interest rate with fixed payments, rather than “buy an option” to let the payments float (which is essentially what RBF does for you).

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Randall Lucas is an investor with Seattle-based RevenueLoan, a pioneer of the Revenue-Based Financing model. He is a reader and occasional contributor to Startup Law Blog, and also writes at blog.revenueloan.com and blog.rlucas.net.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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