Revenue Based Financing: Meaning, Benefits and Comparison

Revenue Based financing is a creative and flexible form of financing arrangement which provides debt and equity financing privileges. Traditionally, an enterprise raises capital through bank loans, debentures/bonds or through the sale of equity shares, which has pros and cons.

In this article, we will discuss the meaning, benefits and types of revenue-based financing. We shall also discuss how revenue-based financing differs from traditional financing.

Meaning of Revenue Based Financing

Revenue-based financing is a form of business finance wherein lenders provide funding in exchange for a share in future revenues. This form of business finance has the flexibility of debt and equity financing.

In this arrangement, the interest payout is linked to the performance of a business. An enterprise does not have to dilute its shareholding for any third party. Certain parameters are also agreed upon, such as loan to be provided, amount to be repaid over time, percentage of revenue shared with financiers and payment frequency (daily, weekly or monthly).

If an enterprise borrows Rs. 25 lakh, the monthly turnover will determine the terms of the contract. A percentage of revenue will be agreed upon through interest payments. For instance, if the percentage is decided as 5%, then if the monthly sales are Rs. 1 crore, Rs. 5 lakh would need to be paid as interest. If the turnover declines to Rs. 80 lakh, then Rs. 4 lakh would need to be paid as interest.

Benefits of Revenue Based Financing

An enterprise can maintain its shareholding by not losing any stake in the business. A fixed amount would need to be repaid over time, similar to debt financing.

The interest obligations are linked to the performance of the business making interest a variable cost to the company. This type of financing is suitable for seasonal businesses. When the business has achieved a lower monthly turnover, it does not need to worry about its interest payment since it will pay lower interest.

Indian MSMEs who face massive credit gaps, due to which these businesses approach informal sources of credit, can switch to revenue-based financing. This saves them interest costs, as interest costs for these are almost half of what is charged for business loans.

Forms of Revenue Based Financing

Invoice discounting is the oldest form of revenue-based financing. Under invoice discounting, a vendor gets instant access to finance based on unpaid invoices in exchange for a small discount. The realisations from unpaid invoices are used to settle the loan. This arrangement provides a breather and helps companies manage their working capital effectively.

How Revenue Based Finance works

Under revenue-based financing, a borrower must pledge a percentage of revenue to the investor. In the end, a borrower repays the principal amount and shares in revenue to the investor.

For example, an enterprise has monthly revenue of Rs.10 lakh. Accordingly, its yearly revenue is calculated as Rs.120 lakh. The investor will examine the enterprise by analysing certain parameters, such as operating margins, scalability, working capital management or future growth potential.

If an investor provides a loan of Rs. 20 lakh against a share in the revenue of 10%. In a month, the revenue for the borrower stands at Rs. 50 lakh. Hence, the total payout to the investor will be Rs. 25 lakh (Rs. 20 lakh + 10% of Rs. 50 lakh).

Comparison between Revenue Based and Traditional Financing

Following is the difference between revenue-based financing and traditional financing

Conclusion

It’s time for Indian MSMEs to embrace alternative forms of financing, such as revenue based financing, for an effective low cost of funding.