A revenue-based structure for direct investments in small and growing businesses is beginning to gain currency among so-called angel and impact investors.

Revenue-based financing (RBF) is a modern iteration of traditional royalties. Rather than taking a share in the business, investors receive a share of a company's revenues that can amount to up to two to five times the original investment. Since companies only make payments when they actually have cash flow, the rate of return depends on how long it takes to get that money back. In general, though, investors are shooting for an internal rate of return ranging from 18 percent to 30 percent.

"I'm a raving fan because I think [RBF] aligns interests [between investors and entrepreneurs] better than a lot of traditional investment vehicles," says Jerry Carleton, an attorney with the Immix Law Group in Portland, Ore., which has organized 24 RBF financings over the last five years.

He says the 2008 financial crash created a huge divide between the values investors put on companies and what companies thought they were worth. One beauty of RBF, he points out, is that it renders the valuation conversation--often an awkward and belabored one--irrelevant. He has used the technique to raise funds for manufacturing and service businesses as well as high tech.

The advantage to investors is that they can begin earning returns right away rather than waiting several years for a company to be acquired or go public. Most early-stage deals, of course, don't pan out at all.

RBF can also be a good deal for entrepreneurs. For one thing, they do not have to give up a huge stake in their company to obtain growth capital. If they have a liquidity event later and they've paid back their investors, they will be able to reap all the gains.

RBF financing carries an effective interest rate of around 25 percent, meaning it's more expensive than bank debt. But that also brings advantages. Arthur Fox, chairman of Royalty Capital Management in Lexington, Mass., who is widely credited with innovating the RBF technique in the early l990s, says that he structures these deals as debt so entrepreneurs can take advantage of interest deductions.

By treating the amount a company pays back in an RBF deal—minus the original investment—as interest, it can be used as a tax deduction, according to Fox.

Beyond that, he points out, banks require payments even when companies lose, say, a major customer or otherwise hit a rough patch. "The bank might forbear that situation for a month or two, " he says. "But [after that], they will foreclose on your company--and actually kill it. ...Then they'll come after your house.

"That's expensive," he says.

Most RBF investors prefer to finance companies that already have revenues of $1 million and gross margins of at least 18 percent to 24 percent—or 50 percent or higher in the case of high tech.

But investors are experimenting with RBF in a variety of ways. In Seattle, serial entrepreneur Michael "Luni" Libes, who has been an entrepreneur-in-residence at the University of Washington and the Bainbridge Graduate Institute, where he also teaches entrepreneurship, has started Fledge, a "conscious company" incubator based on the TechStars model. Like TechStars, he mentors start-ups in exchange for 6 percent of the company. In his case, though, RBS accounts for half of that. Arguing that the average venture capital return on an entire portfolio after losses is just under three times the original investment, he charges Fledge entrepreneurs 3 percent of their cash flow until they have paid him back $30,000, or three times his investment.

"This model allows me to support entrepreneurs that are establishing lifestyle businesses," he says.

Lighter Capital, also in Seattle, is using RBS to make $50,000 to $200,000 loans to very early-stage technology companies with minimum revenues of $15,000 per month and gross margins of at least 50%. Many of these firms are at breakeven but are so cash-strapped that they have no funds for sales and marketing. "Say you've shown that if you spend $50,000 on Google AdWords, it will take you from $500,000 to $1.5 million in revenues," says Lighter Capital CEO BJ Lackland. "We will fund that."

Whereas Lackland says he is "agnostic" about whether his clients want to run their business forever or flip it and start again, impact investors are drawn to RBF precisely because it does not require an exit. "Exits are destabilizing events for employees and for the community," says Juliana Eades, president of the New Hampshire Community Loan Fund, a community development financial institution that provides loans to small businesses in the state. "I like RBS because it solves the exit problem and it is mission compatible."

The Community Loan Fund, which is industry agnostic, has made 20 RBF loans since 2002. It has used the tool to do things like help finance a new product within an established company with an experienced management team and to provide equity-like growth capital to a successful equity-backed company whose investors did not want ownership dilution.

Another impact investor that's embracing RBF is the VSJF Flexible Capital Fund, a for-profit subsidiary of the Vermont Sustainable Jobs Fund. Charged with accelerating Vermont's green economy, its mission is to provide "near equity" (subordinated debt as well as royalty financing) to fill a gap and strengthen the state's sustainable agriculture and food systems, renewable energy and natural resource sector. Its first deal was with Vermont Smoke & Cure, a smokehouse that does private-label work for farmers. But whereas most RBF funders do stand-alone deals, the Flex Fund collaborated with seven other funders to provide the right mix of capital.

"We are working with companies that are built to last; hence, we are looking at sharing in the upside of the business through revenue sharing rather than ownership," says Janice St. Onge, deputy director of the Vermont Sustainable Jobs Fund and president of the VSFJ Flexible Capital Fund. "We're not about working with companies that are built to flip."

A former investment banker, Ellie Winninghoff is a writer and consultant specializing in impact investing. Her blog is at www.dogoodcapitalist.com and she can be reached at [email protected].