Revenue-based financing versus debt financing

If you’re an ambitious business you’ve likely considered raising finance to speed up your growth.

Whether you need to invest in additional inventory, or fund an aggressive marketing campaign, raising finance can help give you the money you need quicker.

Revenue-based finance and debt finance are two popular funding models used by high growth businesses, particularly eCommerce or SaaS companies.

Which you choose will depend largely on your goals, and how you want to raise and service your finance agreement.

In this article we take a closer look at the differences between revenue-based finance and debt financing so you have a better idea which finance type is best for you.

What is Revenue-Based Financing?

Revenue-based finance allows a company to secure financing by selling a percentage of future gross revenue.

For example:

Company 1 could secure $100,000 in finance for an agreed return of $120,000.

As part of the agreement, company 1 commits to pay 5% of its monthly revenue to the investor until the $150,000 has been paid back.

What is Debt Financing?

As the name suggests, debt financing works when a company agrees to sell a “debt instrument” like a bond, to an investor in return for finance.

The value of the loan is known as the principal.

As part of the agreement, the borrower commits to monthly payments until the principal—plus interest—has been fully repaid.

The interest rates associated with debt financing can be fixed or variable, depending on the lender. 

Key Differences Between Revenue-Based Financing and Debt Financing

How is the finance repaid?

With revenue-based finance, repayments are based on a percentage of the borrower’s monthly gross revenue.

This benefits the borrower in that the repayments aren’t fixed, as they’ll fluctuate along with revenue.

For example:

• Month one: Revenue of $100,00 and a payment of $5,000
• Month two: Revenue of $150,000 and a payment of $7,500
• Month three: Revenue of $50,000 and a payment of $2,500

For businesses with fluctuating revenue (or those that experience seasonal peaks, like eCommerce businesses) revenue-based finance can be a great option.

Debt financing on the other hand involves fixed monthly payments until the principle has been repaid.

Although these payments can be manageable, providing your revenue stays consistent, if you experience a drop in sales the payments could become a strain on your balance sheet, and could stop you investing money elsewhere.

Think of debt financing as the classic approach—steady, predictable payments that help you budget long-term, especially if your cash flow is consistent. On the other hand, revenue-based financing is the flexible new kid on the block: payments adjust with your revenue, making it ideal if your income fluctuates or you're in a rapid growth phase. Both keep your equity intact. It just comes down to how you want to handle the ups and downs.

- Andrew Lokenauth, Fractional CFO at Fractional CFO Solutions

Ownership implications

Revenue-based finance is a popular form of finance because it doesn’t require any collateral or guarantees.

It also doesn’t have a fixed repayment date, as you just pay a percentage of your revenues until the finance is repaid.

Debt financing does have fixed payments over a set time that the money needs to be repaid.

If the business is unable to service the debt, it could lead to them losing assets to make up the shortfall.

Risk

One of the big advantages of revenue-based finance is that it removes much of the risk of business loans, because the repayments are linked to revenue performance.

The more revenue you generate, the higher your payments.

If your revenue dips, your payments fall accordingly.

Debt financing carries many of the risks of “traditional” business loans because the payments are fixed, and must be completed in a set time frame.

If you fail to make the payments, you could lose assets.

Cost

Revenue-based finance can be a more cost effective option because your payments are based on a fixed percentage of revenue (for example, 3% of monthly revenue until the finance is repaid) and the repayment amount is agreed beforehand.

Debt financing involves repaying the principal, plus interest, so can be more costly if you borrow more, or hold the debt for a longer period.

Some debt finance agreements involve variable rates of interest, which can further increase costs.

Repayment periods

With revenue-based finance, if your sales grow quickly, you’ll pay more per month and repay your debt quicker.

Because debt financing is based on a fixed payment over a fixed term, even if your sales pick up you’ll still be repaying your debt over the agreed time period, which includes the interest accruing on the loan.

Although you could arrange early repayments, some companies may include penalties.

The critical difference between revenue-based financing (RBF) and debt financing lies in the repayment structure. RBF offers flexibility, allowing repayments based on revenue, which can be ideal for startups with fluctuating income streams. Debt financing, however, requires fixed repayments, making it suitable for businesses with predictable cash flows.

For instance, I worked with a startup in Silicon Valley that benefited greatly from RBF. They had unpredictable revenue, and aligning repayments with their cash inflow helped maintain their financial health. Conversely, a more established client in New York with a steady income found debt financing advantageous due to its predictability and lower interest rates.

- Naschay Rawal, Managing Partner & CPA at NR Tax & Consulting

Availability

Although the time to secure funding can be quick with revenue-based finance, its availability is limited to post-revenue businesses (as they need revenue to base repayments on).

Debt financing can be more readily available to businesses as they just need a debt instrument (like bonds or bills) to exchange for finance.

Which Financing Option is Right for Your Business?

Revenue-based finance and debt financing can both be attractive ways to raise finance for your business.

But the choice ultimately depends on your goals, objectives and what period of business you’re in.

For ambitious eCommerce or SaaS businesses entering a growth phase and in need of cash quickly, revenue-based finance can be the ideal choice without taking on many of the risks associated with traditional loans.

Revenue-based finance can also be a better choice for businesses with consistent revenue looking to grow further, as payments are based on revenue and you don’t need to surrender equity or put up collateral.

However, for smaller businesses, start-ups or those in a pre-revenue phase, debt financing may be the better option.

Although it can carry risks to put up a debt instrument in exchange for finance, it can sometimes be your only option.

This is particularly the case for pre-revenue businesses, which would be unable to access revenue-based financing. 

When evaluating RBF and debt financing, the company's growth potential, cash flow predictability, and risk tolerance play vital roles. For example, at Eyeglasses.com, our predictable cash flow and stable growth made debt financing a strategic choice for us during an expansion phase. On the other hand, companies with variable or seasonal income might stand to benefit from revenue-based financing due to the inherent flexibility.

- Mark Agnew, Founder & CEO at Eyeglasses.com

In terms of choosing between the two, it's crucial to assess a company's needs and growth potential. For example, in the case of my company, Slipintosoft, given the cyclical nature of the textile industry and the rapid growth we've experienced, a revenue-based financing model was more beneficial. It provided us the flexibility to match repayments with income flux, which proved pivotal during seasonal lows. 

- Damon Wu, Founder at Slipintosoft.com

Conclusion

Revenue-based and debt financing offer two very different funding models for businesses in need of a boost.

While revenue-based finance offers flexibility, debt financing carries stricter repayment terms.

When choosing between the two there are some key points to consider.

For example, would you be better served linking repayments to revenue rather than facing fixed amounts every month?

Do you have the consistent revenue to meet your payment obligations?

Do you want to avoid putting up collateral in exchange for your finance?

How you choose to finance your business can have substantial, long-standing implications on your future success.

Find out more about the value of revenue-based finance to ambitious, high growth focused businesses.