Revenue Loans
Let’s talk about revenue loans – their structure, cost and when they might best be used.
We have recently seen impressive growth of a new flavour of financing for e-commerce and subscription-based companies – the revenue loan. Let’s have a look at the structure and real cost of revenue loans in the context of other financing options.
Our view is these facilities are well suited to help smooth out working capital needs. Their rapid (6-12 month) repayment cycle means they are less well suited for mid-long term planning where capital is best provided by equity or term loans. Revenue loans are marketed as ‘no-dilution and no-interest’ loans. Rather than charging interest, like a standard bank or venture debt loan would, revenue loans are paid as an upfront, fixed percentage cost (a flat fee) on the capital loaned.
In addition, revenue loans provide relative flexibility as to how they can be used for various expenses from marketing through to inventory purchases.
Cost of Capital – why internal rate of return (IRR) and cash flow timing matters.
A typical revenue loan from a European lender charges a 6% to12% upfront flat fee on the capital loaned. The fee is repaid upfront by the borrower (the startup) by way of the capital loaned being immediately ‘reduced’ (debited) with the flat fee when the loan is initiated. This fee forms part of a revenue share agreement which typically runs for six months.
Modeling this out with the lower end 6% fee scenario results in an IRR for the lender of 20-30% (the calculation in the spreadsheet below has it as 26.8%) with a cash-on-cash return multiple of 1.06x.
A quick side note to illustrate the effect that timeframe has on IRR:
If you borrow $100 today which you repay as $106 one year from today the implied interest rate (also called Internal Rate of Return, IRR for short) would be 6%. If you repaid that $106 in six months the IRR would be approximately 12%. And if you paid six monthly payments of $17.67 (for $106 total) the IRR would be over 20%.
The faster you repay a flat rate fee the higher the IRR will be.
Breaking this down further:
The cash-on-cash return of 1.06x looks to be low. On the surface, a 6% fee seems cheap when comparing it to other sources of capital, but the time cost of capital is quite high (an IRR of 26.8%).
Why is this so?
From the lender’s perspective
The revenue lender is repaid the full loan in equal payments over six months. The fast repayment allows the lender to turn the capital multiple times and redeploy it to numerous companies in a year. An additional benefit for the lender is that this strategy diversifies its credit risk.
So what does this mean for the startup?
It is true that this funding is non-dilutive, and easy to implement, but a 6% upfront fee is not apples-to-apples vs. a 6% annual interest rate. The implied interest rate (IRR) is in the 20-30% range given how quickly the capital repays.
Looking at this within the broader context of venture capital returns
A typical venture capital fund that funds companies at the early stage will look for a >30% gross IRR on investments over 5-10 years (i.e. 4-13x cash-on-cash return to make this IRR work across the fund life). Assuming that most founders aim to be successful long term at the point of raising early capital, this equity cost of capital is relatively similar to a ‘no dilution, no interest’ revenue loan of (26.8% IRR). The difference is the cash flow timings. In the scenario of a venture capital (VC) funded company, the equity cost may come in 5-10 years and is conditional on success. With the revenue loan, it will come in six months regardless of success.
Typically, a venture lending fund that provides debt to high growth, VC-backed startups looks at repayment over 3-4 years. The loans will have an interest payment of 10% to 12% (annual rate), closing/repayment fees of 1-2% and a warrant to purchase shares for 1% to 2% of the company. Putting all of this together, assuming the warrants generate a 3x return in 6 years then the venture loan would generate an IRR of 17-18%.
Consideration should be given to VC commitment
Warrants make venture loans look expensive but remember the venture lender is only making money on these instruments when other investors and typically when founders make money. As such there is long-term alignment with the team and investors vs a non-dilutive revenue loan where in any scenario the lender gets their 6% fee. Put differently, the revenue lender is agnostic to the company’s long-term success and only attentive to their ability to survive over the initial six months.
Summary:
What does this mean for startups?
Management teams should look at both the cost of capital (measured by IRR) and the cash-on-cash cost of any source of capital they evaluate. A revenue loan over six months at a 6% flat fee does not mean the cost of capital is 6%.
The investor perspective
All things being equal, revenue lenders are intriguing businesses as they can get equity-like returns (20-30% IRR+) whilst taking debt-like risk (senior to equity, highly diversified, liquid instruments as they are repaid daily/monthly etc). This reflects a very good conceptual risk-adjusted return with a low downside and a good yield (especially in a low interest rate environment).
The short (6-12 month) duration of repayments mean the lender can re-evaluate whether it wants to continue extending credit twice per year. This is a much safer position than the 5+ year view equity investors and 3+ year view venture lenders must take.
The company perspective – how to best use revenue loans
Although the financing cost (IRR) may be close to the cost of equity, revenue loans have some benefits for startups.
First, the providers advertise a simple process with initial terms given after completing an online form.
Second, the loans are well suited to help top up working capital in order to financing short-term liabilities. This can be especially helpful for companies with seasonal cash flows or have renewals more heavily weighted to the end of the quarter.
If using this type of capital to fund longer-term liabilities (such as ongoing operational burn), be careful to assess the risk of the lender choosing to not renew the facility which could leave a company in a difficult position.
Adapted from the blog, Crossing the Pond “Revenue Loans: New Year, better math please” by George Bartlett. George is part of the investment team at Columbia Lake Partners.