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Why revenue sharing can be an interesting alternative to typical startup equity funding

The most expensive capital a founder will ever raise is their first equity offering. When sourcing capital, startup founders typically use one of two basic structures, debt or equity. With debt financing, the startup is paying back an investor’s loan with interest. Equity means the startup provides a portion of the ownership of the company to the investor in exchange for cash.

Recently I have started to see more of an interesting alternative for the typical debt or equity start-up funding. That is revenue sharing or revenue based financing (RBF). At its very basic, revenue sharing is a form of a loan that’s repaid by sharing operating profits with investors as return on their investment. The point of this article is simply to give you a glance at a new and creative alternative to the typical equity or debt structure for startup funding.

While revenue-based or royalty financing seems a relatively new financing model, it has historically been used in the oil, gas and mineral industries for many years. Speculators invested in oil, gas or mineral extraction companies in exchange for a percentage of earnings from successful operations.

As with many startups, venture capital is not always a viable source to raise capital from and banks are reluctant to loan money to new or small businesses without financial history or collateral. And if you are trying to trade dollars for equity with friends and family things aren’t as easy even on that front. “What most of those investors fail to recognize, in order for them to get a return on their investment, there has to be a liquidity event in the business. This critical point gets lost in all the excitement of writing their check. I can assure you; it will resurface in the coming years when uncle Larry wants to a return on his capital. It makes for difficult dynamic for both the investor and founder, especially if the founder has no interest in selling the business.”, said Chris Russell, Managing Partner | GSD Capital, “Revenue-Based Financing has the potential to solve the inherent problems involved with equity fundraising while also offering the needed repayment flexibility early ventures require for a successful outcome.”

A revenue-based agreement can provide the kind of flexibility or “patient capital” designed to help the small startups with funding.

Structuring capital for a startup can be a challenge in any form. There are obviously many elements to consider when trying to structure a revenue sharing offering, like how revenues are calculated, the relationship between marginal revenue and total revenue just to name two. Chris Russell, Managing Partner | GSD Capital comments, “The challenge for FF investors, there aren’t well defined templates available for their use. It’s not like a promissory note where an attorney will have a database of templates at his disposal. So it will require some expense to have legal counsel draft documents.”

The primary benefit of a revenue share investment structure is that both startup founders and investors are aligned towards the goal of creating sustainable revenue. Investors are repaid incrementally as the company generates sales that ends up being 1.5 to 2.5 times the original amount until paid in full. There is no one royalty or revenue-based financing agreement. As
with most loans, these agreements can be tailored to the needs of the business and the investors. Instead of a fixed interest rate of return and fixed monthly payment, the parties agree to a total repayment amount above the original loan to be paid over time pursuant to the agreed-upon
percentage of revenues.

Entrepreneurs benefit from a flexible payment to investors that are directly proportional to how well the company performs. If the company’s revenue growth is faster than expected, investors are repaid over a shorter period of time. Typically this arrangement is best suited for businesses with high gross margins of 40% or higher to really make it work for the entrepreneur.

For investors revenue sharing on revenue growth instead an exit based on an acquisition or IPO  means their focus is concentrated on the company’s financials for future revenues. Typically revenue share investors may not sit on the board or advise on business like they would for an equity investment, but they are incentivized to see the company succeed.

If you are raising funds with an equity offering from the typical friends and family, a revenue base funding maybe a good alternative particularly the structure is inherently easier to understand.

There is a lot of adoption for this funding model with local crowdfunding sites and the larger better known site like Indiegogo. There are also a plethora of new programs being offered by companies like Lighter Capital or GSD Capital

This article originally appeared on medium.com

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