Start-ups often face a consequential decision once they've bootstrapped their way to $5 million or more in revenue. Should they pursue further growth by raising equity capital, but relinquish some control over their business to investors and dilute ownership? Or should they take out a loan and manage to the expectations of the lender as set out in warrants or covenants?

In at least some respects there's a third alternative: revenue-based financing. This is a type of loan without encumbrances like warrants and covenants, and with debt service set as a percentage of revenue, so if a business thrives its payments go up and if it hits a lull its payments go down.  

"The loan is designed around the concept that, as a company grows, it can afford to pay more, and if it's smaller, debt service is lower," Wayne Cantwell, managing partner at Decathlon Capital Partners, told CFO Dive. 

As with any type of loan, borrowers must use the money tactically. If they push for growth too aggressively, they can put themselves in a difficult position when the loan term ends. But if they exercise prudence, they can come to the end of the loan with something they could never get with equity — their ownership interest intact. 

"We've all heard stories of a lot of equity being taken by investors even though the entrepreneur did all the hard work," said Cantwell, who started Decathlon in 2009 with a partner after working in the venture capital space. "With this financing, when you're done, you’re done. There's no baggage; they work their way through it, and move on."

Decade-old industry

Revenue-based financing as a capital niche has been around for about 10 years; a number of firms compete in the space. Among some of the others are Lighter Capital, launched in 2010, and Clearbank, launched in 2015. 

The industry has grown largely by word of mouth, and today it's an important part of the finance mix for start-ups, Cantwell believes. 

"When we started, nobody knew anything about this," he said. "It's just the simple fact that more people ask someone, 'We're looking for some capital. What do you think?' And they go, 'Oh, you should try revenue-based capital.'"

Decathlon looks for companies earning between $5 million and $50 million in revenue, growing by at least 10% annually, although it mostly works with companies growing between 15% and 30%. It likes to see companies with high gross margins, something that can mean very different things depending on the industry. For a company with high fixed costs, that might be 25%; for a software-as-a-service (SaaS) company, that might be 85% or higher.

For Cantwell's company, SaaS businesses comprise the biggest part of its portfolio — around 40% — but it makes loans in a range of industries, including non-SaaS technology, logistics, healthcare, food and beverage and business-to-consumer. The key to succeeding with this variety is flexible underwriting. 

"The mechanics, or valuation metrics, are so different by industry, you have to take that into consideration," he said. 

Loan terms are relatively long-term — usually five years — and debt service is typically between 1% and 4% of revenue, depending on the industry, company size, growth rate, and the size of the loan.

"You could have a company that's under $10 million in revenue and growing at 20% and they only want $1 million," said Cantwell. "That would create a percentage of revenue that might be different than a $10 million company that's growing at 30% and wanted $2 million. So, the calculus behind that changes with every deal."

Loan differentiator

In addition to having debt service set as a percentage of revenue, a main differentiator between revenue-based financing and institutional loans is an absence of covenants or warrants. 

"That's part of what the companies like," said Cantwell. "They're not trying to manage to a bank's expectations; they're really trying to manage growing the business and succeed at what they do."

Covenants under a bank term loan typically include performance metrics borrowers have to meet to stay in good standing. In some cases the requirements can be strict, like having a certain amount kept in reserves or maintaining a certain level of earnings before interest, taxes, depreciation and amortization (EBITDA). 

"Because of their regulatory environment, or the way they credit underwriting, banks will often require a company to have, say, $500,000 of EBITDA no matter what," he said. "A lot of small businesses get in a lot of trouble."

For revenue-based lenders whose borrowers get into trouble, they have the same remedy available to them as any traditional lender: a UCC-1 filing.

Under uniform commercial code rules, lenders can claim as collateral whatever drives the value in the business. That can mean contracts, client lists, or physical assets like vehicles. 

"You're working on the notion of, 'What are the ways we can monetize the collateral?'" he said. "We're identical to anyone else in that respect."

Next stages

For the typical borrower his company works with, the next stage in their financial needs might very well be an equity raise, but it also might be nothing. It’s possible they've grown enough to stand on their own.

"They could have enough EBITDA profitability they're not needing to raise more," he said. 

If they're a SaaS company, the most likely next step is an equity raise, even if at the moment they don't need the money.

"It might be that, by year three, they say, 'Wow, our monthly recurring revenue (MRR) is growing nicely every year,'" he said. "'We don't need a $10 million round right now, but if in two years we get the company to x, then that may make a lot more sense.' And by the way, they've delayed dilution. So, in that case, it's pretty obvious their next round is probably equity."

For companies that don't want to raise equity but don't want to stand entirely on their own, the next step is likely to be a working capital loan to capitalize their receivables or inventory. 

"Maybe they've gone from $10 million to $30 million and they make plenty of money, so they don't need to grow capital but they still need debt," he said. "They don't typically go to a bank for a term loan, because, generally, by the time they get to that point, their needs are different."

A company with high fixed expenditures, like a manufacturer, is a likely exception, Cantwell said. "If you need to buy $2 million worth of equipment, you’ve got Small Business Administration loans or other things like that."

That kind of loan generally isn’t what revenue-based financing firms provide. But for start-ups looking for money to grow without the dilution that comes with equity or the performance requirements that come with institutional loans, revenue-based financing is an increasingly familiar third option.