Revenue-Based Financing – Growth Capital or Working Capital?

Whereas “revenue-based financing,” or RBF, was a relatively obscure term for a form of “alternative venture capital” a few years ago, the phrase has experienced a surge in popularity over these last few years. Yet, it can also be a source of confusion as it has come to refer to a broad set of alternatives to venture capital (VC), often without differentiating between them.

Many likely associate the term with platforms like Pipe, Capchase, and Uncapped, which offer short-term (~12-18 month) loans, expressed in different forms (typically fixed monthly payments, sometimes with revenue share and either lent at a discount or paid-back at a premium). As these platforms have, perhaps ironically, raised enormous sums of venture money, they have driven awareness of all forms of alternative VC – which collectively seem to have attracted the general term of revenue-based financing. There is also a cohort of investors, like Riverside Acceleration Capital with its growth loan offering, that have used the term RBF in the past, though which are longer-term in nature.

Given the shared marketing language, these options can look similar on the surface. When you look under the hood, however, you’ll start to see that the “RBF” landscape tends to bifurcate, with each of these models more suited to a particular use case or type of business than the other. Broadly, these models can be categorized into short-term options (generally focused on working capital) and longer-term options (growth capital).

In this post, we’ll do our best to break down the most common models, how they work, and when they might be a good option.

Short-Term (6-24 month term) Options: essentially working capital

Much of the growth in the RBF market, in the past couple of years, has been driven by those lending on a short-term basis – typically with a 6-12-month term and from programmatic lenders or fintech platforms. 

While this form of financing can be used as growth capital in certain instances, its rapid-repayment timeline is typically suited for short-term capital needs. It’s often used to cover one-time cash payments or unusually low cash-flow months. Sometimes marketing-led consumer-focused businesses can leverage these loans to help fuel growth, but generally need a quick payback on new customer acquisition costs given the need to repay the loan in short-order. Otherwise, these short-term loans are leveraged as “working capital,” and the quick repayment horizon is offset by a low cash-on-cash (CoC) cost (though the internal rate of return (IRR) or “effective interest rate” underlying the repayment is often much higher).

There are, generally, two types of instruments that fall into this working capital category: Upfront capital/cash advance and short-term loans.

Upfront capital or cash advance services (for example, Pipe and Capchase’s Grow offering) provide companies with a way to get paid upfront for future receivables. They work by “annualizing” customer contracts (typically paid monthly or quarterly) and providing a lump sum cash advance at a discount.

For example, if you have a customer that pays $10k every month, your annual contract value would be $120k. One of these services might “buy” that contract for a discount (perhaps $108k), and you would be on the hook for paying the lender $10k/mo. for the next 12 months – the original terms of the customer contract (though usually not directly tied to that customer as the capital would require repayment even if that customer changes contract or churns).

In many ways, upfront capital is an innovation on traditional A/R Factoring, which has been around for many years, but was previously unavailable to software companies that get paid upfront, rather than in arrears (as a services business or manufacturer might). This sort of factoring can fill immediate cash flow gaps, and the seemingly low cost (expressed as a percentage of the loan amount, typically ~2-12% from what we’ve seen, depending upon the repayment timeline) “feels” like a cheap price to pay. They are also often low work to procure and sometimes fully automated, which provides fast turnaround.

However, this sort of capital would be difficult to use as growth capital – at least for a B2B company – given the short repayment cycle. (The example above would see 11% of the $108K repaid each month.) Therefore, the use cases are limited to short-term needs, rather than needs like most B2B marketing campaigns or sales hiring, which are investments that generally take more time to generate returns. Also given the short-term nature, the effective interest rate (or IRR for the lender) for that relatively small repayment premium is actually fairly high – often around 25-30%.

Short-term loans are typically royalty-based loans (although they can be more traditional loans) generally paid back over 1-2 years. These loans offer many of the benefits of classic revenue-based financing: No dilution, no personal guarantees as collateral, and no fixed monthly payments. Return caps vary based on provider and several factors related to a company’s financial history and use of funds. In general, if you borrow $100k, you’re likely looking at paying back $106-110k over a 6 to 12-month period.

A major benefit of a short-term loan (just as with cash advances) is the speedy process. You can often qualify in minutes using an automated process and see the funds in your bank account within 1-3 business days. However, these loans have a fixed total return for the lender, with quick repayment timelines. Thus, the effective interest rate (or cost of capital) can be deceiving – similar to what’s outlined above at 20-30%, even if something like a 7% fee for a 6-month loan appears inexpensive.

Though some of the lenders in the short-term market are explicit about where their capital is best used (either as working capital or e-commerce growth capital), others are less upfront and advertise themselves as inexpensive growth capital. At least from a B2B context, most are better used for working capital. The short time horizon means businesses will need to start paying the capital back right away, which doesn’t offer the leeway needed to ramp up longer-term growth initiatives. These efforts (like hiring a sales leader or investing in new product development) often take many months to start showing return on investment (ROI), which means the onus to pay back these short-term loans falls on existing revenue streams. Companies we’ve spoken with refer to this type of pressure as a “treadmill,” where they must go back and borrow more money in a few months just to buy more time for their new initiatives to start paying dividends. Once you are in that situation, the relatively low ~6-10% CoC cost on each successive loan multiplies quickly.

Using short-term options for growth capital may make more sense for ecommerce and B2C businesses, or some B2SMB businesses without human sales intervention, where you can expect a relatively quick return on growth initiatives. For example, an ecommerce business could use the capital to invest in paid advertising and expect a quick increase in revenue, which could be used to pay back the initial sum. An enterprise SaaS company with a multi-month sales cycle would need significantly longer to show ROI.

Nonetheless, both options can be useful when short-term cash is needed, as long as you are confident in your ability to pay them back within the time horizon.

Mid-to-Long-Term (3-5 year term) Options: growth capital funding

The second category of funding is designed for investing in new initiatives that are critical to the longer-term success of a company but less likely to make an immediate impact on revenue. We’ve covered several of these use cases in a previous blog post, and they include everything from financing key new hires to expansion into a new market, geography, or product line.

This type of funding can be considered a non-dilutive alternative to venture capital. It’s long-term debt that is meant to either replace VC or prepare a company for VC/Growth Equity down the road. It does still need to be repaid, but unlike with a cash advance or traditional loan, payments are variable and tied to a company’s cash flow. Payments can be thought of similar to a royalty, taking a small share off the top of a company’s revenue each month. This means that if a company is having a down month, where revenues are lower than usual, their payment will be proportionately reduced. Inversely, if a company has a series of great months, they’re able to pay off the loan faster. The nature of this model often means that payments can be substantial towards the back-half of the term, but generally the first year or two is relatively low repayment. The intent is to allow the capital to be invested into longer-horizon initiatives and repaid as the results of those initiatives kick-in.

On a strict cash basis, this type of revenue-based financing usually requires a higher CoC return than a short-term loan, to compensate for the longer time to repayment, and overall CoC return typically varies with length of the loan and other repayment dynamics.  Generally, the longer the loan term, and the longer it takes to repay the loan, the higher the CoC return.  The longer term allows for more flexibility and smaller monthly payments, and if payments are delayed it allows more capital to be used for growth. In that way, as it allows for real investment into growth initiatives (that may take some time to bear fruit), which makes it an alternative to traditional venture capital.  From a CoC perspective, in comparison to venture capital it often ends up being cheaper, especially in the event of a successful event as it enables founders and their teams to hold onto more equity. We’ve modeled a few hypothetical exit situations in a previous blog post.

Many of the companies we work with at Riverside Acceleration Capital use our funding to grow out a sales team or expand their addressable market by launching into a new geography or vertical. These efforts are critical to proving the level of scalability investors look for (a proof point increasingly important for growth equity fundraising especially around crossing milestones like $10M in revenue), but like most growth initiatives, will typically take at least a year to generate the type of results you can hang your hat on.

Other companies we work with view revenue-based financing as a way to bridge to profitability.  These companies typically have experienced capital-efficient growth and just need a bit more momentum before they’re in the green. With revenue-based financing, they can make that leap while ensuring that their founders and team can hang on to as much of their equity as possible.

Even within this category, revenue-based growth capital can vary greatly based on the time horizon, with options for mid-term and long-term deals.

Mid-term growth capital providers generally offer 2–3-year loans with a relatively quick and simple process. They often invest in a high volume of companies and take a hands-off approach. These loans can provide bridge financing ahead of a pending exit or break-even, but they do require fairly quick repayment so they can be costly as you get more towards the higher end of the return cap for a 3-year loan.

Long-term growth capital providers typically deal in 4-5-year time horizons. These deals are often larger, and many longer-term revenue-based financing providers take a more hands-on approach, offering support and resources to help a company navigate its growth journey. This is the category Riverside Acceleration Capital belongs to, and the one we describe further in our RBF Primer.

An investment tailored to your business

If the idea of a long-term growth capital partner appeals to you, we’d love to get in touch.

RAC’s revenue-based financing model is tailored to the needs of a growing software company and designed to help maximize value and optionality for the businesses we work with. We invest in only a small number of companies each year, enabling us to build a long-term partnership with each and offer hands-on support through our dedicated growth advisors and the relationships, tools, and knowledge of The Riverside Company. We’re also able to fund across multiple rounds, through both additional RBF investments ($1-5M) and traditional growth equity investments ($5-15M).

You can learn more about our model and schedule time with the team by visiting www.riverside.ac