Among the options available to small businesses, revenue-based financing (RBF) seems to be getting more attention recently. It’s structured like a loan and the repayment is tied to a percentage of the company’s monthly revenue. The main attraction for entrepreneurs, accordingly, is that it’s promoted as a way to finance rapid growth without giving up equity and control.
These loan products are marketed through niche lenders. And like much in the internet age, the promise is that the deal can be done quickly and with less documentation. But as we shall see, they are much more expensive than conventional financing through a bank or a nonprofit lender, such as CEDF.
Looking at some of the funders’ websites showed some variety in the terms. The minimum monthly revenue of the business might range from $15K to $30K. Maximum funding was listed as 1/3 of annual revenue in once case and six times monthly recurring revenue in another. To qualify, businesses have to have gross margins better than 50%. This is because if one has to budget 3% to 10% of monthly revenue (debited out of your bank account) to repay the financing, there had better be enough profit left over to run operations.
The term repayment cap is used to describe the total cost of capital. This can range from 1.3 times to 3 times the amount borrowed. On the low side that would mean repaying $65K on a $50K loan or even $150K on the same $50K financing. A three-year $50K SBA Microloan at 7.5% would have a total repayment of $55,991, which equates to only 1.12X the financed amount. The terms are said to be three to five years, which is comparable to an SBA Microloan. So one can see there is an enormous cost associated with the corner-cutting that an RBF might provide when it comes to the application and qualification process.
Of course, it might be comforting to think that as revenue fluctuates the repayment commitment will flex too. But the lenders have baked this into their own qualifications. That’s why they are offering to fund businesses with subscription-based or other stable revenue sources.
Bottom line is that old-fashioned loans from banks or alternatives from community lenders are still the least expensive way to borrow, unless of course, your Uncle Bob is simply willing to forgive your debt.
For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it? Luke 14:28 KJV
This Bible verse is not about Jesus giving real estate development or small business financial advice but for the sake of some entrepreneurs I wish He would have. Sadly, it is not an infrequent occurrence that CEDF’s lending department receives applications related to stalled projects. The owner thought they had enough money but they ran out because of unforeseen responsibilities imposed by government regulations, increases in the price of equipment or materials, delays in construction, etc.
Sometimes these situations are obviously foreseeable, some are pure bad luck. But the common factor in three examples that I have heard about lately, and the element that makes these head-slappingly tragic is that a lease was signed before a carefully considered set of cost estimates was totaled.
Of course, you might say, you have to sign a lease and get possession of the space in order to start building, and only then do you discover the overruns.
But the scenarios I’ve seen aren’t the bad luck kind, they’re the reckless, hope for the best, “I’m sure we can finish for cheap” sort of problems. And they come up frequently.
Something in the impatient psyche of an entrepreneur makes them believe that the location they have chosen is the last one on earth suitable for their project. And naturally the landlord or leasing agent has revealed that several other serious parties are ready to commit and snatch the opportunity away. Indeed, they will never forget this one.
As usual, Warren Buffet's 2019 shareholder letter has drawn attention for what some may consider to be a surprising risk to his insurance portfolio -- a cyber security disaster comparable to a catastrophic earthquake. He's talking about an event or string of events that disrupts society and shuts down businesses with a significant impact on the economy.
First, the author argues complacency is affecting CEOs. There are so many reported breaches and attacks, that it's beginning to be viewed as just a routine part of running a business. But others – probably small business owners -- negligently ignore the threats, feeling resigned to their inability to effectively deal with events that seems common but unpredictable like a tornado or other extreme weather disaster.
The second piece of advice is to accept the reality that the enemy has any individual company out-matched and that outsourcing to specialists is the only sensible place to begin (once your head is out of the sand). Here's where small businesses with limited resources, again, face special risk because they give up the fight. It’s like saying you aren’t going to sweep the sawdust and crumpled paper off of your shop floor just because you don't have an elaborate sprinkler system.
Finally, the author points out that the government may be warning business owners, but it's not going to help. Don't expect the FBI to roll back a ransomware attack or remediate your data breach. In fact, the regulatory arms of the government will hold you accountable for negligence (which includes inaction) as a lesson to others.
It’s not unusual for a borrower to submit a loan proposal to a bank or a community lender like CEDF for more money than the numbers will support. It’s our obligation to make sure that the ratio called global debt service is in line with reality. This means considering all of the financial obligations of the borrower personally, as well as the capabilities of the business, can the loan be repaid at the contemplated terms? We won’t offer the loan if this condition can’t be met.
That’s also why typical loan covenants forbid a borrower taking on more outside debt without a lender’s approval. It can rock the boat and make the ship roll over.
Sometimes, if only a lesser loan amount can be supported, the loan officer will ask the applicant if the business plan can be realistically changed and still work. This is entirely a business judgement of the applicant. The lender wants to accommodate by approving a modified proposal, but a lender can’t promise that a smaller loan is workable.
Sadly, the enthusiasm and determination of borrowers sometimes outweighs their judgement. It’s frustrating when a CEDF business advisor, trying to help a distressed client some months down the line, hears the peril that the client is facing was caused, “because you didn’t give me enough money.” The unwelcome truth is that had the client been allowed to borrow more, odds are the bottom might have dropped out even sooner.
Another fantasy of inexperienced small business owners is the idea that getting free of debt and raising big money in the equity markets is somehow a dream come true. Appropriate debt financing is cheaper than equity financing. There’s no shame in using it.