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.