WHAT IS INCOME-BASED FINANCING?
Income-based financing (RBF), also known as royalty-based financing, is a unique form of financing provided by RBF investors to small and medium-sized businesses in exchange for an agreed percentage of a company’s gross income.
The equity provider receives monthly payments until its invested capital is repaid, along with a multiple of that invested capital.
Mutual funds that provide this unique form of financing are known as RBF funds.
TERMINOLOGY
– The monthly payments are called royalty payments.
– The percentage of income that the company pays to the provider of capital is called the royalty rate.
– The multiple of the invested capital that the company pays to the capital provider is called the cap.
CASE STUDY
Most RBF capital providers are looking for a 20% to 25% return on their investment.
Let’s use a very simple example: If a company receives $ 1 million from an RBF capital provider, the company is expected to pay $ 200,000 to $ 250,000 per year to the capital provider. That works out to about $ 17,000 to $ 21,000 paid per month by the company to the investor.
As such, the capital provider expects to receive the invested capital within 4-5 years.
WHAT IS THE ROYALTY RATE?
Each equity provider determines its own expected royalty rate. In our simple example above, we can work backwards to determine the rate.
Suppose the company produces $ 5 million in gross revenue per year. As stated above, they received $ 1 million from the equity provider. They are paying $ 200,000 to the investor every year.
The royalty rate in this example is $ 200,000 / $ 5M = 4%
VARIABLE ROYALTY RATE
Royalty payments are proportional to the top line of business. All things being equal, the higher the revenue the business generates, the higher the monthly royalty payments the business makes to the provider of capital.
Traditional debt consists of fixed payments. Therefore, the RBF scenario seems unfair. In a way, business owners are being punished for their hard work and success in growing the business.
To remedy this problem, most royalty financing agreements incorporate a variable royalty rate program. In this way, the higher the income, the lower the royalty rate applied.
The exact schedule of the sliding scale is negotiated between the parties involved and is clearly described in the term sheet and the contract.
HOW DOES A COMPANY GET OUT OF THE INCOME BASED FINANCING AGREEMENT?
All businesses, especially technology businesses, that grow very fast will eventually outgrow their need for this form of financing.
As the company’s balance sheet and income statement strengthens, the company will move up the funding ladder and attract the attention of more traditional financing solution providers. The business may be eligible for traditional debt at cheaper interest rates.
As such, each income-based financing agreement describes how a business can buy from or buy from the equity provider.
Purchase option:
The business owner always has the option to purchase a part of the royalty agreement. The specific terms for a reduced purchase option vary for each transaction.
Generally, the equity provider expects to receive a certain specified percentage (or multiple) of its invested capital before the business owner can exercise the purchase option.
The business owner can exercise the option by making a single payment or multiple balloon payments to the equity provider. The payment reduces a certain percentage of the royalty agreement. The invested capital and monthly royalty payments will be reduced by a proportional percentage.
Purchase option:
In some cases, the business may decide that it wants to buy and extinguish the entire royalty financing agreement.
This often occurs when the business is sold and the acquirer chooses not to proceed with the financing agreement. Or when the company has become strong enough to access cheaper sources of financing and wants to restructure financially.
In this scenario, the company has the option to buy the entire royalty agreement for a predetermined multiple of the total capital invested. This multiple is commonly known as the limit. The specific terms for a purchase option vary for each transaction.
USE OF FUNDS
Generally, there are no restrictions on how a company can use RBF capital. Unlike a traditional debt agreement, there are few or no restrictive debt agreements on how the company can use the funds.
The equity provider allows business managers to use the funds as they see fit to grow the business.
Acquisition financing:
Many technology companies use RBF funds to acquire other companies in order to accelerate their growth. RBF capital providers encourage this form of growth because it increases the revenue to which their royalty rate can be applied.
As the business grows by acquisition, the RBF fund receives higher royalty payments and therefore benefits from the growth. As such, RBF financing can be a great source of acquisition financing for a technology company.
BENEFITS OF INCOME-BASED FINANCING FOR TECHNOLOGY COMPANIES
No assets, no personal guarantees, no traditional debt:
Tech businesses are unique in that they rarely have traditional assets like real estate, machinery, or equipment. Tech companies are powered by intellectual capital and intellectual property.
These intangible intellectual property assets are difficult to value. As such, traditional lenders place little or no value on them. This makes it extremely difficult for small and medium-sized technology companies to access traditional financing.
Income-based financing does not require a business to guarantee financing with any assets. No personal guarantees are required from business owners. In a traditional bank loan, the bank often requires personal guarantees from the owners and pursues the personal assets of the owners in the event of default.
The interests of the capital provider RBF are aligned with the business owner:
Tech companies can scale faster than traditional companies. As such, revenue can grow rapidly, allowing the company to pay royalties quickly. On the other hand, a poor product brought to market can destroy business revenue just as quickly.
A traditional creditor, such as a bank, receives fixed payments on debt from a business debtor, regardless of whether the business grows or contracts. During lean times, the company makes the exact same debt payments to the bank.
The interests of an RBF capital provider are aligned with those of the business owner. If business income declines, the RBF capital provider receives less money. If business income increases, the provider of capital receives more money.
As such, the RBF provider wants business revenue to grow rapidly so that it can share the benefits. All parties benefit from business revenue growth.
High gross margins:
Most technology companies generate higher gross margins than traditional companies. These higher margins make the RBF affordable for technology companies in many different sectors.
RBF funds look for companies with high margins that can comfortably afford monthly royalty payments.
No equity, no board seats, no loss of control:
The provider of capital participates in the success of the business, but does not receive any participation in the business. As such, the cost of capital in an RBF deal is cheaper in financial and operational terms than a comparable capital investment.
RBF capital providers have no interest in participating in the management of the business. The scope of your active participation is the review of the monthly income reports received from the business management team to apply the appropriate RBF royalty rate.
A traditional equity investor hopes to have a strong voice in the way the business is run. Expect a seat on the dash and some level of control.
A traditional equity investor expects to receive a significantly higher multiple of his or her invested capital when the company is sold. This is because you take a higher risk, rarely receiving financial compensation until the business is sold.
Capital cost:
The capital provider RBF receives payments every month. The business does not have to be sold to make a return. This means that the capital provider RBF can afford to accept lower returns. That is why it is cheaper than traditional stocks.
On the other hand, RBF is riskier than traditional debt. A bank receives fixed monthly payments regardless of the finances of the business. The capital provider RBF may lose its entire investment if the venture fails.
On the balance sheet, RBF is between a bank loan and equity. As such, RBF is generally more expensive than traditional debt financing, but cheaper than traditional equity.
Funds can be received in 30 to 60 days:
Unlike traditional investments in debt or equity, the RBF does not require months of due diligence or complex valuations.
As such, the turnaround time between submitting a financing condition sheet to the business owner and funds disbursed to the business can be as low as 30 to 60 days.
Businesses that need money immediately can benefit from this fast turnaround time.
