For small business owners, getting the capital you need through a bank loan to maintain and grow your business can be a lengthy and difficult process, especially over the past two years as interest rates continue to rise and traditional banks have tightened their lending requirements as a result. Small business loan applicants must have excellent credit and a strong cash flow to even be considered for a loan.
There are, however, certain financing products that have risen to prominence that allow small business owners access to working capital without having to face difficult requirements, give up equity in their business, or fill out lengthy paperwork. One of those products is revenue-based financing, an alternative way to get funds based on your business’s future revenue.
What is Revenue-Based Financing?
Revenue-based financing – sometimes referred to as sales-based or royalty-based financing – is a unique funding method in which a financing “fronts” a lump sum of cash to a small business in exchange for a predetermined percentage, or “factor” of that business’ future sales. In essence, the financing company is purchasing a business’s future sales at a discounted rate.
Let’s say that a financial institution, typically an alternative lender, fronts $100,000 in a revenue-based financing deal to a small business with a factor rate of 1.2. That means that, over time, the business owner will pay 20% of their sales on a daily, weekly or monthly basis back to the financing company until $120,000 has been paid off. There is no set date for when the payments end, they only end until the owed amount has been paid.
Unlike a traditional small business loan which requires fixed payments, there are no fixed monthly payments in a revenue-based financing arrangement. If sales go down, the factor rate won’t change, but the amount being paid back will go down since you’re paying a percentage of your sales to pay back the “fronted” amount.
Why and When Revenue-Based Financing is Needed
Since revenue-based financing is more expensive than a loan or line of credit, it is not for everyone. If you’re seeking to invest in the long-term growth of your business by adding more space, increasing inventory, or hiring additional staff, then a bank loan is a very good financing tool if you qualify.
Revenue-based financing, however, is a great form of financing when you need cash quickly for immediate expenses, short-term growth targets and emergencies. While it is more expensive than a bank loan, it is also easier to qualify for if your business has a strong sales history or can otherwise demonstrate the ability to produce future sales. Generally, you want to make sure your small business is making enough in sales to remain profitable under the terms of a revenue-based financing agreement. Also, since the approval for revenue-based financing is largely dependent on sales history, the financing company will typically place less weight on your personal credit during the underwriting process.
Here are just a few examples of when businesses could use revenue-based financing:
- A small construction company is awarded a large contract but needs cash quickly to purchase inventory and hire additional workers. That small business can receive $700,000 through revenue-based financing to fulfill the obligations set in the contract. If the contract is worth $2 million and the company has a factor rate of 1.2 and must pay back $840,000, the revenue-based financing deal would be well worth it, especially if the construction company does not qualify for a bank loan or line of credit.
- A small, two-year-old retail store borrowed money from investors when it launched and has produced $250,000 in annual sales. That business needs cash to expand but doesn’t want to dilute its earnings with additional investors. Since most lenders would reject an application for a bank loan from a company that’s only two years old, that small business owner can borrow $50,000 through a revenue-based financing deal and use those funds for immediate expansion, while slowly paying back the money through increased sales due to expansion.
- A small software firm is seeking to quickly develop and launch a new product that is expected to increase sales by 20%. However, the owner does not want to pull capital away from other units to pay for the $250,000 in marketing, research, and development that it will take to launch the new product. With a revenue-based financing deal, the firm can get those funds quickly, and the sales of the new product will exceed the cost of capital in the revenue-based financing deal.
Essentially, the rule of thumb for revenue-based financing use is that the cost of the funds you receive in the agreement should be covered by the growth opportunity you are funding while still giving you profit. The idea being that, without the funding, you would not have been able to move forward with your project and would have lost all of that potential revenue.
How is Revenue-Based Financing Different from a Loan?
While revenue-based financing does front your business money, it differs significantly from a traditional business loan. The most significant differences are:
Easier to obtain.
The biggest difference between a loan and a revenue-based financing deal is accessibility. Obtaining revenue-based financing is substantially easier than obtaining a loan. A bank loan usually requires:
- A good to excellent credit score;
- Several years in business;
- A strong cash flow;
- In some cases, a business plan presentation, and
- A compelling plan on how you will use the proceeds of the loan.
The qualifications for revenue-based financing, however, are considerably less since this form of financing relies heavily on the strength of your sales. When you apply for revenue-based financing, you will often only need:
- A fair credit score in the mid-600s, depending on the lender;
- Typically two years in business, and
- A strong sales history.
No default risk.
With a traditional loan, you must pay back the borrowed amount with interest over a predetermined period. If you fail to make your payments in that confined time frame, you will default on your loan. With revenue-based financing, you don’t have this same risk of defaulting. Instead, you will keep paying the pre-agreed-upon percentage of your future sales until the money that’s been fronted to you is paid back. If sales are low, your payment amount is smaller. If sales are great, your payment amount is larger.
Quicker funding.
Loans from traditional lenders often take time to obtain – sometimes weeks – especially if you’re trying to get a SBA 7(a) loan. Revenue-based financing is typically offered by alternative lenders and non-bank financing companies and requires less paperwork than traditional lenders. In the case of revenue-based financing, the application is far simpler than for a loan, and funding can come in as little as 24 hours.
Revenue-based financing is more expensive.
While revenue-based financing has some unique advantages over traditional loans, small businesses must keep in mind that generally, factor rates are more expensive than an interest rate on a loan, so it’s important to carefully weigh the pros and cons of each before deciding on the type of financing to apply for.
Revenue-Based Financing is Changing the Lending Landscape
Data indicates that with the advent of alternative lenders (the predominant financial institutions that offer revenue-based financing), this type of funding has changed the landscape of the small business lending market over the past 15 years. While revenue-based financing has been available to small business owners for the past two decades, it has gained massive popularity as an alternative financing source for small business owners who need funding quickly and may not have all of the qualifications for a loan or do not have the time required to wait on approval for a small business loan.
During periods over the past 15 years when loan requirements from traditional banks tighten and bank loans become harder to obtain, revenue-based has soared in popularity. According to the Federal Reserve of St. Louis, in 2010, two years after the Great Recession, the volume of revenue-based financing grew to $524 million – nearly double the amount from three years prior. According to a study conducted by Benziga Research, the global revenue-based financing market size was valued at $2.8 billion in 2022 and is forecasted to grow to $4.9 billion by 2028.
Economic Woes Bolster Revenue Based Financing
Rising interest rates since March 2022 coupled with rising inflation since the end of the COVID-19 pandemic, caused the cost of capital on bank loans to skyrocket and traditional banks to demand higher borrowing standards such as excellent credit scores and higher cash flows than in the past.
According to the Federal Reserve, applications by small businesses for bank loans and lines of credit decreased from 89% in 2020 to 72% in 2022. Approvals for loans and lines of credit dropped to 68% in 2023 from 76% in 2020. In the Federal Reserve’s latest study, 10% of small businesses that applied for financing in 2022 sought revenue-based financing. That figure was up from 8% in 2020 – when interest rates were very low – and 9% from 2019.
Additionally, approval rates on small business loans and lines of credit have decreased dramatically, making an alternative lending option such as revenue-based financing all the more attractive. Approval rates by traditional banks were 83% in 2019, the year before the COVID-19 pandemic, and fell to 68% at the end of 2022.
Pros and Cons of Revenue-Based Financing
As much as revenue-based financing can be an extremely valuable financing tool, it must be emphasized that this type of funding isn’t for everyone nor for every situation, as it’s more expensive than a traditional bank loan and line of credit. However, while bank loans and lines of credit are excellent financing tools, they often carry high borrowing requirements and, therefore, may be difficult to obtain for some small businesses.
Revenue-based financing is a great funding tool under the right circumstances, but it does have potential downsides. It’s extremely important for any small business owner to closely examine the pros and cons of revenue-based financing before choosing this as a financing option.
Pros of Revenue-Based Financing
- Revenue-based financing is easier to obtain than a loan or line of credit. Since the main requirement is a strong sales history, you don’t need an excellent credit score or three years in business to obtain revenue-based financing.
- There is no default risk since payments are based on a factor of future sales.
- Business owners don’t have to give up equity to obtain revenue-based financing like they would with private equity.
- revenue-based financing is a good way to boost your short-term cash flow without having to meet the often stringent requirements of bank loans or lines of credit.
Cons of Revenue-Based Financing
- revenue-based financing is more expensive than a loan. Depending upon the strength of your sales and your credit rating, the cost of capital can be significantly higher than a loan or line of credit.
- In a typical revenue-based financing arrangement, the payments you make are variable and based upon how strong your sales are. Therefore, if sales are slow, the payment arrangement can last for an extended period of time.
- You may get rejected for revenue-based financing funding if you don’t have a strong sales history.
- You need a strong cash flow to obtain revenue-based financing funding. For bank loans, most lenders will closely examine your cash flow to see if you qualify. Revenue-based financing providers mostly focus on your sales history. Therefore, if you have high monthly expenses and don’t adjust them to make a revenue-based financing arrangement, your business could lose money since you are giving up a percentage of your sales in a revenue-based financing deal.
How to Obtain Revenue-Based Financing
Alternative lenders that operate mostly online offer revenue-based financing funding, so a quick online search can give you an expansive list of providers. Reputable revenue-based financing providers do have requirements for obtaining this form of funding, including
- A credit score in the mid-600s
- 2 years in business, and
- At least $250,000 in annual revenue.
Watch out for Bad Actors
Some states are tightening regulations surrounding revenue-based financing, but it remains a loosely regulated industry. Therefore, when searching for a revenue-based financing provider, you may come across some predatory financing companies that are claiming to be legitimate. When researching alternative financial institutions that do offer revenue-based financing, here are some of the signs you should look for that may indicate a “bad actor”:
- It will offer you funding despite a very low FICO score (under 600).
- It does not have bonafide customer reviews.
- It does not offer strong customer service or is difficult to reach.
- It will try to rush a deal before carefully going over specific terms with you.
- It will try to downplay or gloss over abusive terms of funding, such as exorbitantly high factor rates and transaction fees.
- The lender’s history in business is obscure or difficult to research.
Consult a Small Business Financing Specialist
Many reputable financing companies offer small business financing specialists who can assist you in deciding whether revenue-based financing is a good option for your business, and you should work closely with them. The main thing to do is to examine whether you will be using the funding to increase your profits to the point that you can pay the factor rate and still be profitable.
You should also go over the timeliness of receiving funding – are you in need of cash right away and have a strong sales history, or are you seeking to borrow funds for long-term growth? Does your sales history justify a revenue-based financing arrangement? Finally, like with any financing product, you need to go over the specific terms of repayment to make sure you can comfortably afford them.