For many businesses that don’t catch the eye of equity investors, revenue-based funding (RBF) can be a powerful growth tool. Unleashing its potential, however, requires a mindset that goes beyond an equity-oriented approach to investment.
When more than 150 investors join a national working group to discuss revenue-based financing (RBF), as happened recently, it’s clear that the concept has arrived.
Vested for Growth has deployed RBF for the past 16 years (we have referred to it as royalty, or mezzanine, financing). We've made 45 such investments totaling close to $15 million with a 12% internal rate of return since the pilot became a program in 2007.
Beyond helping business owners find the right investment vehicle, RBF also spreads entrepreneurship more broadly throughout the financial ecosystem.
RBF is gaining prominence in conversations about growth capital products for small-business entrepreneurs. The growth models of many businesses that offer moderate levels of risk and reward can look unattractive to banks and equity investors (institutional VCs and individual angels). Banks interpret insufficient collateral or a secondary form of repayment as risks exceeding what either their policies or regulators will allow. On the other hand, equity investors see underwhelming reward potential.
This is where RBF enters. A deal structure based on revenue—a hybrid of debt and equity— is well aligned with the moderate-risk/moderate-reward profiles of most business growth plans. These companies are neither “gazelles”— the fast-running, built-for-quick-exit darlings of VC and angel investors— nor the low-risk businesses that represent safe bets for banks’ transactional debt products.
Kauffman Foundation’s Capital Access Lab is looking to catalyze new financing approaches that serve the 81% of entrepreneurs who do not access bank or venture capital. This middle group of privately held businesses deserves more support as they position themselves for growth and consider acquisitions, entering new markets, or introducing new products.
But there is a set of success factors for RBF that goes well beyond the capital-for-revenue deal structuring tool. Those factors are rooted in a shift in the investors’ attitude and approach.
With the best of intentions, RBF investors often approach funding through an equity lens. That makes perfect sense given that growth capital’s norms have been defined by equity, and that many RBF practitioners are former equity investors. But approaching and delivering RBF through an equity lens risks overlooking the opportunity to serve many more businesses. RBF investors need to shift away from an equity orientation in seven key areas.
1. Look beyond startups
New-on-the-scene businesses most often catch equity investors’ attention. Startups with fast-growth strategies and highly disruptive value propositions are encouraged to pursue equity, and they make their presence known to VC investors and angels.
However, businesses with a minimum $500K-$1M of revenue are among the best suited for RBF as they seek to achieve their next growth stage. These are often the businesses that drive our local/rural economies. Existing businesses often need growth capital for acquisitions, to introduce new products/services to the market, or to build a new channel to take products into new markets.
2. Actively seek opportunities
Equity investors are highly sought after by businesses seeking investment. With no shortage of startups seeking funding, many investors spend so much time filtering through pitches and proposals that actively seeking investment opportunities seems like a waste of time and resources. At the same time, entrepreneurs for whom RBF is ideal, are likely unaware that such a deal structure exists. When their bank lender is unable to finance all or part of their growth plan, they may dismiss growth capital entirely. If they are uncomfortable with equity’s requirements – such as giving up decision-making control, diluting their ownership or putting the business on a 3- to 5-year track to be sold – they may simply shelve the growth plan.
This is bad for the business, for the community and for the broader economy. RBF investors need to make themselves visible in that moment and actively present an alternative to funding the business’s growth plan. Becoming more present in the community, finding out what companies have had a growth plan deemed (completely or in part) unbankable, and approaching prospective partners are key shifts that support successful RBF investments. There is also still a lot of education needed to help other funders and investors understand the value of working with RBF funders.
3. Consider opportunities beyond your expertise
Investors’ appetites are often narrowed by the belief that they personally need a high level of relevant industry expertise in order to be successful investors. By contrast, since RBF investors don’t have a decision-making role in the partnership, they are a useful sounding board and seek to match the entrepreneur (the actual decision maker) with appropriate experts in their broad network. RBF investors still add value by asking good questions, but it will likely be supplemented through an advisory board, CEO peer group, or other experts.
This opens the field of RBF prospects to any business with a strong management team and growth proposition, coachable leadership, and a gross profit margin of at least 25 percent. This financial threshold is due to RBF’s “pay as you grow” approach, which requires strong cash flow.
4. Recalibrate your idea of success
An equity filter that screens only for propositions capable of delivering 5 to 10x return multiples sidelines a lot of good businesses with solid growth plans. This is logical; institutional equity investors need a few grand slams to compensate for the churn or multiple start-up/early stage investments that strike out.
A successful RBF approach, however, asks investors to understand that winning doesn’t require always swinging for the fences. Just like in the movie Moneyball, solid singles and doubles (and the occasional triple) with only a few strikeouts can be the basis of a strong portfolio.
The time-value of money is another contributing factor. Equity investments usually generate no return for three to five years, a span that diminishes their eventual internal rate of return (IRR). RBF investors, on the other hand, receive income the month after closing the deal. A long series of small, consistent somethings often outperforms a series of nothings that ends,with a large payday, That is because that payday must cover losses from the previous investments before its reward is visible.
RBF investors who can get excited about the prospect of an 18-percent return open a bigger window of possibilities and position themselves and the businesses they invest in for mutual reward.
5. Break out of silos
Equity investors often team up with other equity investors, but RBF success often requires partnering with other types of capital.
Successful investors will help entrepreneurs understand what tools they really need and support their ability to tap into a range of debt, royalty, or equity-centered structures at different stages of growth and for different reasons.
6. Commit to the long game
Equity portfolios often do better when investors cut their losses early and focus on the likeliest top earners. By contrast, when RBF investors have a bias toward “staying in the relationship” this can be a sound approach. Growth plans don’t always come to fruition as quickly as planned. Our experience is that if company management is transparent— incorporating lessons learned and adapting—patience often facilitates success and preserves investments.
7. Work in a mutually beneficial partnership
In many ways, equity investors have considerable power to set the rules, and often begin with their own business valuation and a take a “take it or leave it” approach to negotiations. RBF is built on partnership with the business’s management team from initial deal making to the final payment.
While an RBF investor may have an overall internal rate of return target, the negotiation as to how to structure the deal is more nuanced and must work for both the investor and the business. RBF is a pay-as-you-grow model; an investment that, if structured in ways that are difficult, the business won’t succeed. While the goals of an equity investor and an entrepreneur start out aligned, they can diverge over time. Those deals often end with the entrepreneur wanting to continue to grow the company while the investors have an incentive to sell the company. Alignment is baked into RBF investments because the return is harvested through a model based on monthly payments and does not require the sale of the business.
RBF’s more-expansive approach offers investors a broader set of growth-ready businesses but requires fundamentally different approaches to investing and partnership. Beyond helping business owners find the right investment vehicle, RBF also spreads entrepreneurship more broadly throughout the financial ecosystem.
Supporting entrepreneurs who survive the startup stage, then sharing those stories of next-stage success makes starting a business a more-compelling and more-accessible proposition. These examples of success can encourage entrepreneurship beyond the categories of the high-tech startups and the typical entrepreneurship profile that command equity investors’ attention. This is how RBF lives up to its true calling.
John Hamilton leads Vested for Growth, the RBF (aka royalty) focused arm of the New Hampshire Community Loan Fund. For the past 20 years, VFG has been a pioneer in the use of revenue-based funding for community economic development.