Revenue-Based Finance & The Cost of Capital

How much does revenue capital cost?  In other words, how expensive is revenue-based financing (RBF) as a source of venture funding compared to equity and traditional loans?

Rather than vaulting into financial engineering, Greek equations and Modigliani-Miller debates, consider the following first-hand account:[i]

“I’ve got a problem coming up with the bank.  It goes back to the $7.65 million loan that we took out in August 2007 to purchase a new building for our business.  We managed to avoid foreclosure last year by agreeing to turn the deed over to the bank, which gave us a five-year lease on the property in return.  Our monthly payments (including rent and taxes) would start at about $25,000 for the first year and then rise annually to about $80,000 in the fifth year.  At the time, I was relieved.  I mean, we were eight months behind on our payments, and the bank had personal guarantees from me, my two brothers, my two cousins, my mom, and my uncle.  We could have lost everything.  The problem is, our monthly payment is due to go up to about $62,000 in September, and I don’t know if we can cover it.  Business is better, but not that much better.  Any advice?

‒      Mike Baicher, President, West End Express, Dayton, New Jersey” [ii]

West End Express was a thriving commercial trucking and warehousing company that watched in horror as its sales crashed with the recession.  Before the crash West End put $850,000 down on a new facility, and could handle its $70,000 monthly payment.  After the crash it could barely afford $40,000 per month.  As a result West End lost ownership of its property (kiss that $850,000 down payment good by) and was forced into a new deal that it still could not afford, just to spare its family abrupt destitution.[iii] If conditions do not improve, the family could still lose its business before year-end because it can no more afford the new payment than the last one.

The question is… what was its cost of capital?  Whatever the cost, it certainly isn’t captured by a hollow APR (annual percentage rate) or CAPM (capital asset pricing model).

Cost of capital is a function of risk.  Everyone knows that.  More risk, higher cost; less risk, lower cost.  But what does that really mean?

From an entrepreneur’s perspective, risk is the sum of downside tangible + intangible scenarios at a ratio of approximately 20/80 (20% of the risk is tangible, 80% is intangible).  This is problematic because only “tangible” sums tend to show up in mathematical calculations, leaving the majority of risk assessment obfuscated for unwary entrepreneurs.  There’s no substitute for actually thinking it through.

For example, a 2% APR loan is offensively expensive if borrowers must also amputate their right legs, abandon their first-born children and only wear Spandex (no offense to Spandex-lovers).  Meanwhile a 30 year fixed 1,000% APR loan may come at a bargain if the cash produces guaranteed eternal bliss, world peace and unlimited calorie-free cheese fondue (still looking for that deal… by the way).

It would be absurd to ask a venture capitalist for the “APR” of an equity investment because there simply isn’t one – returns are a function of the venture’s future performance.  APR only comes into play when both the time and magnitude of repayment are predetermined.  Neither is the case in venture capital, thus a VC’s downside risk is near total (the business could go bust), whereas risk to the entrepreneur is limited (no personal liability).  “If you can’t tell me your equivalent ‘APR’ is going to be at least 100% a year” …the VC might reply… “you should get the @#$% out of my office!”

It’s equally absurd to ask an RBF investor for the “APR” of a revenue-based investment because there simply isn’t one – returns are a function of the venture’s future performance.  Neither the time or magnitude of repayment are predetermined in an RBF agreement (only a maximum future potential magnitude is agreed upon), with the RBF investor’s downside risk being near total (the business could go bust), whereas risk to the entrepreneur is limited (no personal liability and variable payments fluctuate to match actual cash flows).  In fact, the actuarial portfolio risk of an RBF investor can exceed that of a VC since RBF investors limit (i.e. ‘cap’) their total potential payback.  By comparison, VCs can enjoy unlimited returns and can hold their equity as long as they want to.  What’s more expensive, a 5% royalty up until a 3X multiple (ex. RBF), or 15% ownership of your company in perpetuity (venture capital)?  Think about it.

In the real world, it’s misleading to ask which offers the best “cost of capital” when the pragmatic question is; “which tradeoffs best match the needs of my business today?”  With that in mind, the following represents key generalized strengths and weaknesses of each capital structure:

Small Business Debt Mezzanine Debt Revenue Capital (RBF) Equity
‒ 6-15% Effective APR (fixed or variable)‒ Small deal sizes (i.e. loan amounts)

‒  Mandatory minimum payments that sometimes increase over time

‒ Personal financial liability to guarantee repayment

‒ Collateral

‒  Can include other debt covenants (balloon payment, debt coverage ratio requirements, etc.)

‒  14-25% Effective APR (fixed or variable)‒  Larger deal sizes

‒  Often reserved for firms with $10 million or more in revenue

‒  Mandatory minimum payments that sometimes increase over time

‒  Personal financial liability to guarantee repayment

‒  Collateral

‒  Can include other debt covenants  (balloon payment, debt coverage ratio requirements, upside ‘kickers,’ etc.)

‒    1-5% royalty on monthly gross revenue as accrued‒    2X-5X “cap” (sum of total repayments as a multiple of the principal investment)

‒    Variable payments (a % of monthly revenue as accrued)

‒    Limited deal sizes relative to revenue (many investors only offer up to 10-25% of historical revenue amounts).  This varies from investor to investor

‒    No personal financial liability

‒    May or may not include collateral (tangible or intangible assets)

‒    Generally “covenant light,” although this too can vary depending on the investor

‒  Lost ownership % of business and dilution‒  Loss of control (ex. Board seat, voting rights)

‒  Large deal sizes

‒  No payments until exit/liquidation event (unless dividend or distribution rights are created and exercised)

‒  No personal financial liability

‒  No collateral (beyond stock ownership)

‒  Pre- and post-money valuations

‒  Exit-driven (pressure to quickly sell the business or go IPO)

‒  Can include other covenants (ex. liquidation preferences, guarantees.  Depends on investor)

If an entrepreneur has a strong stomach for downside risk, small business and mezzanine debt are more attractive options.  In that case, repayment is guaranteed and considerations such as APR and the size of mandatory minimum payments become paramount.

If an entrepreneur wants to mitigate downside risk (tangible and intangible), RBF and equity become more attractive.  Repayment is not guaranteed, therefore considerations such as APR and minimum payments become moot, shifting the focus to royalty rate, repayment cap, ownership %, pre-money valuation and other control points.

What about Mike Baicher?  What if West End Express had been able to purchase its building using RBF?  While its payment may have been the same during good economic times, those payments would have declined during the recession in proportion to revenue decreases (since RBF payments are based on a % of revenue).  In other words, West End would have made its payments in good times and bad, never going into default, without having to suffer the shakedown of a shotgun refinancing.  Neither Baicher, his two brothers, two cousins, mom, or his uncle would have faced personal liability and the risk of losing everything.  Therefore, Baicher could have remained focused on running and turning around his business during the downturn, rather than being sucked into the negative death-spiral of defaulting on one bad deal, losing his property investment, being forced to take another bad deal, and being put in a position where he’s still highly likely lose everything before the holidays.

The cost of capital should never be taken lightly, nor should it be calculated incompletely.  It is a function of downside risk, both tangible and intangible, with intangible risks often the most heavily weighted in human terms.  After all, most of us would rather go financially broke rather than seeing Mom become homeless.

For savvy entrepreneurs this creates both burden and opportunity.  On the one hand, there is no “one number” that dispassionately allows for apples-to-apples comparison between each available funding mechanism.  On the other hand, the underlying variety of each structure offers a contoured menu for entrepreneurs.  Choices can be made  to best fit the needs of any one business at any given time, with trade-offs along multiple dimensions rather than just one.  This is good news for those prepared to think for themselves, and for entrepreneurs who can appreciate the value of both tangible and intangible risk.  Regrettably these distinctions are not always known, and the full menu of capital choices is not always available.  Just ask Mike Baicher at West End Express.


[i] Norm Brodsky, Inc. The Magazine for Growing Companies, Special Report; Bring on the Entrepreneurs!,  Street Smarts, pp 35-36, (July/August 2010)

[ii] Id

[iii] Id

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