So you’re thinking revenue-based financing might be a good choice for you? Make sure all of the following considerations hold true before accepting an offer for your startup.
Think carefully about how the loan you are considering will affect your company’s financial picture, not only how much you’ll owe and how you’ll pay it back, but also stipulations that could restrict your future options. Look at the following:
- Debt percentage. Your company’s debt should be less than 33% of annual revenue. This is called “The 33% Rule”: Debt greater than 33% of annual revenue is unhealthy for startups. Don’t do it. It’s not likely to end well for either your startup or the lender.
- Repayment ability. Your company’s growth should soon cover your debt payments. If growth in gross profit is larger than the debt payments, the loan gives you a net positive cash position (and even better value appreciation). Revenue-based financing has an extremely positive effect when loan payments are less than revenue growth multiplied by gross margin.
Example of a positive cash position: Imagine a company with debt payments at 4% of revenue and 80% gross margins. The company only needs to grow revenue 5% to make the debt payments and have the same cash flow for operations. All revenue growth above 5% is both positive cash flow and, of course, value appreciation without dilution.
- No warrants or minimal warrants. Warrants are a right to buy equity in the future at a price established today. For example, the right to buy 1% of the shares in your company for $X per share (usually the current valuation). Many venture debt 13 lenders require warrants and expect roughly half of their total returns will come from warrants (and half from interest payments). If your startup does well, the warrant can be worth a lot of money to the lender. Three main problems with warrants:
- Warrants dilute your ownership, so do the math on how much any warrant will cost you, assuming you meet your projections.
- Warrants align interests between the lender and a startup in good times, but they don’t align interests if your startup doesn’t grow as quickly you want.
- Many lenders require a “put option.” This gives the lender the right to sell the warrant back to the company after a certain number of years. You have to assume you’ll be required to make this payment, which can be very large and hinder your startup’s ability to grow.
Options. Ensure that the structure of the lending provides options for the entrepreneur. Ask the following questions before you borrow:
- Can you get additional capital from the lender over time with improved terms as your startup grows?
- Can you take out a bank loan? Will the lender subordinate their loan to a bank? Banks provide the cheapest capital possible, so you want to keep that option open.
- Are the pre-payment terms fair? This will be essential if you decide you want to raise equity.
- Is there a personal guarantee? If one is required and you don’t have enough collateral to put up, that option is off the table for you.
- Are there reasonable (or no) financial covenants? Tight covenants hinder operating your startup as you want and may come with large and surprising downsides. Beware: A bad actor lender + tight covenants = startup death.