It can be challenging to know whether your company should take revenue-based financing or a term loan when looking at venture debt. However, comparing the costs, benefits, and risks of each will help you make the best decision for your company.
Comparing loans isn't straightforward
Revenue-based financing (RBF) secures capital on the revenues generated by your company. It views recurring revenue as the asset on which the lender secures the loan.
Typically a pre-agreed percentage of your revenues each month is accepted as payment. However, many RBF lenders use multiples (i.e., 1.6x payback) in the SaaS finance world instead of interest rates to determine how much you will pay for access to the funding.
This makes it hard to compare revenue-based financing to term loans. While the percentage of revenue for your payment will be known, the dollar amount and repayment period are unknown.
Cost of Capital
To truly know your cost of capital, you need to factor in the time you'll have access to the funds.
For example, say you take revenue-based financing for $1m at a 2.2x repayment multiple. You pay back 7% of your revenue each month with a target term length of five years.
Depending on how quickly your company grows, you may end up repaying that loan early. However, regardless of when you pay off the loan, you'll have paid $1.2m for access to that $1m in capital.
If you borrow $1m with a more traditional, fixed interest rate loan (i.e., a term loan) using amortization, the amount you pay will be dependent on the term and can be mapped out at the start of the loan.
Because of these differences, we recommend looking at three main factors when comparing revenue-based financing to traditional loans:
1. The cash flow impact of each loan
2. The fixed interest rate vs. the effective interest rates over the target term length (Note: You'll need to estimate when the loan will be fully repaid.)
3. Risks inherent with each type of financing.
Looking at the Cash Flow Impact
With revenue-based financing, your first year of payments will likely be lower because your revenue won't have grown enough to cause the payment to be as high as that of a term loan. However, as you continue to grow, your payments will increase, limiting your benefit from the increased revenue.
Term loans with fixed interest rates will offer a steady payment the entire term, but the initial payments might be higher than RBF loans. As a result, this arrangement doesn't always suit the use of the loan for growth purposes.
Some lenders will offer an interest-only payment with a term loan. This will have similar cash flow benefits to revenue-based financing by allowing lower payment at the beginning of the term.
Comparing interest rates
The variable timeline of when revenue-based finance gets repaid causes the cost of capital to vary significantly. Therefore, calculating an effective interest rate is complicated because you don't know exactly when you'll pay back the loan.
Tools such as Excel can help greatly. However, an easier way is to use the interest rate calculator we built. Provide the loan amount, amount to be repaid, and the term length to find an estimated effective interest rate of RBF loans. Then, compare that effective rate with the fixed rate on loans available to you.
Most often, you'll find RBF to have much higher effective interest rates than term loans. But, remember, a lot of the value from revenue-based financing comes from the flexibility of the payments.
Risks associated with each loan
RBF requires you to continue to grow to repay the loan by the end of the term. If you slow down or stop growing, you may still owe money at the end of the term and need to refinance. This refinancing can be costly.
Fixed interest loans minimize this risk because your company should be able to afford the fixed payment after several months of growth.
I.e., the loan becomes self-financing and pays for itself through the growth in revenue.
This is the desired outcome for revenue-based financing as well. However, it has the downside of costing more of your cash flow when your revenue increases.
Watch out for risks within the business covenants as well. Anything that requires you to pay more takes control of your company or requires you to run your business inefficiently.
So which is right for your company?
At Element, we believe companies looking for venture debt should already be on solid ground financially. As a result, these companies rarely worry about the fixed payment. Therefore, the additional cost of RBF and the certainty of payment amount causes most of our clients to choose fixed.
Many customers still want to pursue RBF for their business, and we are proud to offer some of the industry's simplest terms and best rates.
To further explore RBF and find your repayment percentage, try our Revenue Based Financing Calculator, or talk to us.