We’ve Heard About SAFEs, But What About RBFs?

Written by: Saranjit Dhindsa

Start-ups need financing – that much is clear.

There are many ways early-stage financing can take shape, but it will either take the form of debt (i.e., a bank loan) or equity (i.e., selling shares to investors to raise capital).

One of the most popular forms of early stage outside financing for start-ups comes in the form of a SAFE – a “Simple Agreement for Future Equity.” Developed in 2013 by YCombinator, SAFEs have been viewed as a quick and easy way to secure financing in seed rounds. For more information on them, check out this blog post.[1]

However, there is a new kid on the block – and it goes by the name of Revenue-Based Financing (or RBFs; the “r” is sometimes referred to as “royalty”).

What is RBF?

Revenue-based financing, also known as royalty-based financing, is another method of raising capital from investors. Investors inject growth capital into the business, in exchange for a percentage of future monthly revenues.

The investor receives their share of the business's income, until a predetermined amount has been paid. This amount is often a multiple of the initial investment amount.

For example, if an investor initially invests $1 million, the predetermined amount could be a multiple of 3, or 5 times that initial investment (i.e., $3 million or $5 million).

On its face, RBF sounds a bit like debt financing, but unlike debt, you do not pay interest on the outstanding investment, nor are there any fixed payments. Instead, payments have a directly proportional relationship to the business, as the payment calculations are based on the business's income. So, if a business sees a high number of sales, the royalty payment will be higher, and if the sales slump for a month, the royalty payment will be lower.

RBF is also different from equity financing, as the investor does not have direct ownership of the business. As such, RBF occupies a weird, hybrid space between debt and equity financing.

What Kind of Start-Ups Can Benefit from RBF?

Businesses that are experiencing moderate and hyper-growth can benefit well under RBF. As such, RBF can be a good way for growth companies to secure growth capital. In addition, businesses that are approaching profitability or have become profitable can benefit from RBF. RBF can be used where a company is pre, post or anti-venture capital. It can also be used to extend cash runaway or eliminate the need for a final funding round.

Currently, RBF is most successful with Software-as-a-Service (SaaS) companies. This is because SaaS companies usually have high gross margins and subscription-based revenue models.

So, what are the pros and cons to RBF?[2]

Pros:

RBF is founder-friendly capital, as it allows the founder(s) to maintain control of their company, and minimize equity dilution

The revenue-based payments increase and decrease to match the income of your business, so a business never has to pay a fixed amount that they cannot afford

While RBF still comes with a price tag in the form of monthly payments, equity financing does not have a cap, and consists of a percentage of ownership of the company in perpetuity.

RBF is suitable for higher-risk companies, who may have a difficult time qualifying for traditional bank loans (which may come with a higher interest rates)

Cons:

RBF can be more expensive than a bank loan in the long run, depending on how high the predetermined amount is.

RBF can foil attempts to founder-proof a business as the founder still retains control over the business, thereby preventing equity holders from exercising their ownership power to keep founders in check/oust them if they are harming the business.

RBF also assumes that a business will have some form of income/revenue, as such, investors who are open to an RBF will look for certain requirements. Often, those requirements consider a start-up's median monthly revenue.

While RBF does not require active repayment, it assumes that payment will occur every month, which may cause a company to become tight for cash, especially in the initial start-up phase. As such, this form of financing is probably best reserved for when a product is launched, and sales revenue is beginning to grow.

[1] http://www.businessventureclinic.ca/blog/safes-what-are-they-and-when-are-they-used

[2] https://flowcap.com/founders-guide-to-revenue-based-financing/