Revenue-based Financing and the Velocity of Capital

Imagine a rapidly scaling e-commerce business that needs $500,000 to purchase inventory for the upcoming holiday season, where their sales will double, but cannot wait three months for bank approval. Revenue-based financing has filled that need for speed for small and mid-sized businesses looking to sidestep the red tape of traditional banking. This type of financing is usually structured with terms between 6-24 months, designed for businesses to capture short term, opportunistic investments or cover day-to-day/unforeseen operational costs.

To compensate for the shorter term, RBF is not structured as a traditional loan, but as a purchase of a business’s future receivables, with the cost of capital structured as a fixed fee over the entirety of the term, known as a factor rate. The factor rate simplifies the total cost of the product, as a traditional Annual Percentage Rate (APR) calculation within this context can often appear misleadingly high due to the short-term nature of the financing. The factor rate is a multiple of the funded amount, and can be anywhere between 1.12x and 1.40x. In other words, over the 6–24 month period, for every dollar a business receives, they pay 15-40 cents in addition to the dollar borrowed. The higher fee structure compensates for the product being unsecured, meaning the financing is made without the business giving up an asset as security.

The Velocity of Capital

For a rapidly scaling ecommerce company, $500,000 borrowed, deployed once and repaid over 5 years through a traditional bank loan in many cases is less valuable than $500,000 funded, repaid, and re-deployed 5 times over that same 5 years. The company may now have been able to fund and deploy ~$2,500,000 worth of inventory rather than ~$500,000 over the same period. However, the real transformation happens beyond just the multiplication of capital deployed. With increased sales from added inventory, the company captures wider market demand. The financing becomes an outlet to increase their economies of scale, multiplying their customer base, and their bottom line.

Other perks of the revenue-based financing product include unprecedented speed-to-access of the funds and their non-dilutive quality, meaning that the ownership does not have to give up equity in exchange for the financing. In the long run, the more aggressive fee structure in almost all cases is less costly than giving up equity in the business. Despite these advantages, revenue-based financing carries a complicated reputation.

The Taboo

RBF is also known as sales-based financing, revenue-based investing, merchant debt or merchant cash advance (MCA). In the financing industry, there is a taboo around the term “MCA.” MCA has been predominantly used by small businesses looking for capital that can’t access it from a bank and the MCA industry has been largely unregulated. Because of this, the product has been abused by unscrupulous, predatory brokers and funds with zero intention of serving their clients’ long-term interests. On the other side of things, there are business owners with limited financial literacy, unaware of the structure and high-risk nature of the product and frankly, use the funds for the wrong purposes. Regulation to weed out the bad actors on the provider side and education for the business owners on the consumer side is key as the revenue-based financing industry continues to expand.

Risks of RBF

Undoubtedly, RBF carries its risks. The higher cost of capital, concentrated over a shorter period, can indeed pinch cash flow, especially considering payments in most cases are being made weekly or biweekly, where principal and interest are repaid concurrently. Businesses looking at unsecured funding that desire a monthly, interest-only payment structure typically need to meet a certain EBITDA requirement, earning them a relationship with a more personalized private credit investor. In other words, these types of risk-averse financing structures are for more mature businesses with established profitability.

The Future

Opponents of RBF cite its higher cost, the common propensity for weekly payments, and unethical brokers and lenders who misrepresent the product. However, according to Allied Market Research, it’s here to stay. Their 2024 report valued the revenue-based financing, or revenue-based investing market, at $6.4 billion in 2023 and projected it to reach $178.3 billion by 2033, a whopping 39.4% CAGR. As regulation increases, the RBF provider market will consolidate around trustworthy players, positioning this vital tool to help more businesses.