What Revenue Based Financing Is and Isn’t, and What I Hope It Will Become
First inning thoughts on the growing movement in commercial finance.
The Buzz around RBF
To the extent commercial lending is ever ‘cool,’ revenue based financing (RBF) may be having its moment.
One reason for the excitement is that RBF firms await a tremendous opportunity to help fund the resurgence of our economy. Pent-up demand is expected to propel a period of at least initial economic growth. Small and medium sized businesses already need funding to reopen, restart and expand. New businesses will need capital to start up and grow. Banks, which never fully resumed lending to small businesses at pre-Recession levels, will struggle to fulfill most of this borrowing demand unless regulatory or technological changes enable them to do so profitably. In the meantime, prominent RBF platforms have been adding to their war chests, mobilizing to deploy capital into the recovery.
At the same time a shared vocabulary — or at least a set of accepted talking points — has emerged about the benefits of revenue based financing. Even one-time competitors to RBF firms now evangelize or offer the product. I used to hear VCs debate about whether the traditional venture debt structure, in which a lender took warrants but allowed for some interest-only period before the loan started amortizing, made sense for startups. Today, VCs aren’t just investing in RBF platforms; some are even advancing long-standing arguments about why entrepreneurs who need funding for customer acquisition should take an RBF facility instead of growth equity. Commercial lenders, like my firm, have also come to appreciate the usefulness of RBF products, particularly for businesses that haven’t yet reached the size or level of operating history needed to tap more conventional credit facilities. It seems we are all revenue based financiers now.
With this flurry of developments as a backdrop, I wanted to offer a few thoughts about what revenue based financing is and isn’t, and what I hope the RBF industry can become. While I may not be fully bought in yet on the emergence of revenue as a new asset class, I’m filled with admiration every day for the RBF platforms that have been built and the ways they strive to create positive outcomes in their communities. If nothing else, I hope this post can serve as a first, but by no means final, word in dialogue with others involved in RBF about how to build not just great individual platforms, but a lasting industry that serves the needs of small businesses and investors alike well past the reopening of our economy today.
What Is RBF?
Before going further, let me try to define ‘revenue based financing,’ because I see the term being used to refer to a range of financing products without differentiating them. In this post, I use the term ‘revenue based financing’ to mean either: (i) a royalty-like term loan under which a percentage of a business’ future revenue, when collected, is applied against a set repayment amount due at maturity; or (ii) a discounted sale of future revenue by a business, which the purchaser collects out the business’ cash receipts until a fixed repayment amount has been received. Other than tangentially, I’m not going to touch on the market for bank recurring revenue facilities, which tend to carry financial covenants and are often reserved for VC or PE portfolio companies. Later I’ll address the distinction between an RBF facility as a loan vs. a sale. For now, suffice it to say that an RBF facility enables a business to receive a lump sum of cash upfront in exchange for transferring a portion of its future earnings until its financing provider receives a specified repayment amount.
RBF Compared to Factoring and A/R Financing
If that sounds similar to factoring or other types of A/R financing, that’s because it is. But revenue based financing is distinguishable in at least two meaningful respects.
First, compared to factors, RBF providers take more risk on the revenues they finance. In an RBF deal, the business’ realization of the future revenues it borrows against remains largely contingent on the business’ future delivery of goods or services to its customers. In contrast, factors that purchase, and banks that advance against, uncollected revenues generally require that those revenues be unconditionally earned and therefore recognizable as accounts receivable on the business’ balance sheet and categorizable as collateral under Article 9 of the Uniform Commercial Code. Financing revenues that have not been unconditionally earned is considered riskier than financing receivables, because the business being financed is earlier in its cash conversion cycle and the contracts to be collected on are ‘executory contracts’ that a bankruptcy trustee can reject if the business or its customers become insolvent. This last point is why I expect, at least early on, that most if not all receivables securitized by RBF platforms will consist of the repayment obligations of companies to their RBF providers, not the underlying rights of those companies to receive payment from their customers.
Second, RBF can apply to a wider range of business types than factoring or A/R financing. Even if a company’s revenue has been unconditionally earned and a receivable has been booked, the receivable will usually qualify for sale to a factor or financing by a bank only if the customer that owes payment is a business (not an individual) with good credit and a track record of paying on time. For this reason, both B2B companies that sell to fellow small businesses and B2C companies can find it challenging to obtain receivables financing from factors or banks.
Business Models Tapping RBF Today
How have RBF providers gotten comfortable taking risk that factors and other A/R financing firms haven’t? One reason is that RBF firms tend to charge higher APRs. The other reason is that RBF firms have mainly focused on funding either businesses with predictably recurring revenues or e-commerce merchants that collect customer payments via methods that facilitate frequent repayments on their RBF lines.
i. SaaS/Subscription Revenue Businesses
The virtues of SaaS revenue models are well documented. Because upfront product investment reduces EBITDA and the availability of macro- and firm-specific data makes possible predictive modeling about customer churn, equity investors generally peg SaaS company valuation multiples to ARR instead of EBITDA. To serve the needs of the private equity sponsors that buy SaaS businesses, private credit funds and even some banks have similarly begun to size their loans as a multiple of debt-to-ARR, enabling them to fund deals that would have otherwise been viewed as too highly levered if presented as a multiple of debt-to-EBITDA. That this trend continues suggests that private credit funds have gotten their leverage providers — and banks have gotten their regulators — comfortable with underwriting loans based off of ARR. The approach has been vetted.
Viewed through that lens, it might be fair to sportively call ARR the “eighth wonder of the world” or announce the arrival of ARR as a tradable asset that can be margined against at an appropriate LTV. Especially in situations where customers prepay for subscriptions and deferred revenue constitutes a use of working capital, it makes sense for a business to monetize future revenues through an RBF product to fund new customer acquisition and increase ARR. Assuming the net dollar retention of those customers holds up, the logic should make sense for investors, too. More on that assumption later.
ii. E-Commerce Businesses
Hardly any discussion about how the pandemic has accelerated ongoing trends is complete without touching on the consumer goods sector. The old wisdom about building brand awareness in brick-and-mortar stores has been eroding for some time. Even traditional experiential retail businesses have found themselves needing to adapt to a new normal of reaching and engaging customers online.
Luckily for merchants, an abundance of platforms exists to help them launch e-commerce businesses. And most of those platforms also offer merchants fast funding or easily integrate with third-party financing providers that do. While customer retention is more precarious for e-commerce merchants than SaaS businesses, e-commerce merchants enjoy the benefit of receiving fairly rapid customer payments. As a result, e-commerce RBF providers can collect their repayments as frequently as daily out of a merchant’s batched credit card transactions or bank account. With substantial visibility into merchants’ sales, inventory and expenses, this type of RBF arrangement creates an apparent win-win: the merchant can fund marketing spend or ramp inventory — minimizing the need to stifle conversion by putting items on backorder — and the RBF provider can see that the merchant is spending on the right marketing channels and SKUs, all while lowering its credit exposure through rapid repayment of its advance.
The RBF/MCA Crossover
Notwithstanding innovations in their approaches to origination, funding and perhaps even underwriting, RBF products in the market today remain derivative of credit products that predate them. Term loan RBF facilities harken back to established royalty financing structures in mining and life sciences. Structuring an RBF product as a sale of future revenue, as many e-commerce RBF providers do, calls to mind a more controversial product: the merchant cash advance.
It should be noted that not all e-commerce RBF facilities are merchant cash advances. For instance, the daily payment Square Capital agreement I linked to above is technically structured as a loan. That agreement references an issuing bank as the originator, an arrangement that many non-bank lenders use to remain exempt from state usury law and licensing requirements. The OCC recently adopted a final rule confirming that it will regard the issuing bank as the ‘true lender’ in these structures, though a number of states, including California, have filed suit to invalidate the OCC rule.
At the same time, it should be noted that many e-commerce RBF facilities are essentially MCAs, as observers of the MCA industry have been noting for some time. Merchant cash advances go back at least as far as the 1990s, maybe earlier, but their origin story is not fundamentally different from today’s e-commerce RBF products. According to MCA lore, MCAs were first marketed as a way for payment processing platforms to acquire and retain merchants.
Of course, merchant cash advance funding has since developed from a side-gig for payment processors into a controversial multi-billion dollar industry. Because MCAs are deliberately structured as sales of future revenue, not loans, the product has developed in a less regulated environment than outright commercial lending.
That’s not to suggest that merchant cash advance providers operate outside of governmental oversight altogether. Recently, the FTC brought an enforcement action against a group of MCA defendants that allegedly misled and deceived merchants. An enforcement action brought by the California DFPI resulted in the entry of a consent order requiring, among other things, the MCA provider to refrain from lending in California without obtaining a license and to return payments received in excess of California’s state usury law limit. Legislators in New York and New Jersey have curbed the ability of creditors to enforce confessions of judgment, a remedy that MCAs have long relied on to collect from defaulted merchants.
Nor is any of this to suggest that MCAs don’t address a perceptible need in today’s market. Without readily available funding from other capital providers, small and medium sized businesses turn to MCAs to fill the void. And guidance is available for MCAs on how to properly structure their transactions as sales, not just formally but in substance. E-commerce and other RBF providers can do some good in the economy by finding innovative, less controversial methods for delivering merchant cash advances at lower APRs than the market offers today. As I’ll elaborate, though, I hope our platforms will aspire to do more than just that.
RBF as a Force for Good
While most of this post has consisted of descriptive observations about revenue based financing, I’d like to close on a hopeful note by sharing some prescriptive thoughts about the role that RBF providers can collectively play as a force for good within the financial markets and our communities. To that end, I’d suggest two normative values that the RBF industry can organize around: transparency and inclusion.
Transparency
Transparency to small businesses should be a bedrock commitment of the RBF industry. Many of us involved in tech-enabled lending to small businesses in the last decade were at firms that helped create or signed on to the Small Business Borrowers’ Bill of Rights. Those efforts helped culminate in the passage of SB 1235, a California law requiring truth-in-lending type disclosures for commercial loans, which the DFPI has commenced rulemaking to adopt. While all RBF providers will need to comply with SB 1235 once it takes effect, I’d welcome the opportunity to start a dialogue with other RBF firms about whether to sign on as a group to the current Small Business Borrowers’ Bill of Rights, or perhaps to take steps toward creating a new organization or set of standards addressing the current needs of small business borrowers and the specifics of revenue based financing products.
The roadmap for how we as RBF firms can more transparently use our customers’ data is harder to plot. In a phenomenon that reaches way beyond commercial lending, businesses collect troves of data on the customers who visit their websites or use their apps. Those customers have at best only a partial understanding of how their data is being used. This overall trend may be irreversible, and it has generated real benefits for users by rendering previously mind-numbing tasks frictionless. Still, I’d like to think that in providing credit — a word whose etymology is literally rooted in trust — RBF providers can collaborate in going beyond applicable regulatory requirements to establish a higher standard of transparency in disclosing to our customers where we obtained their information and how we use it. I think we can work to meet such a standard without compromising the ‘secret sauce’ of any of our respective platforms.
Transparency to capital providers and regulators must be a priority, too, especially where RBF firms can be a bellwether for risks that extend beyond our firms and industry. In particular, I’m thinking about the unique vantage point our firms will have into the realization and collection of recurring revenues for small and medium sized businesses. Like others, I continue to believe in the resilience and investability of recurring revenue business models. I have no more reason to believe that SaaS customers will cancel their subscriptions than a mortgage market observer in the early- to mid-2000s had to fear homeowners missing their payments en masse. But I worry that a law of large numbers approach to assessing ARR deals, left unscrutinized, can devolve into a perceived transubstantiation of ARR into accounts receivable without regard to the details inherent in actually booking and collecting revenues. RBF firms can serve as a check on shared assumptions and sound early warning signs to the market if revenue recognition or collection for small and medium sized recurring revenue businesses stalls more than just episodically. Recent history reminds us how expanding credit to previously unfinanceable borrowers and securitizing the risk can leave financial markets vulnerable to seemingly unthinkable events in ways that are not obvious to predict. Given how much value in the economy is tied directly and indirectly to investments in recurring revenue businesses, we as RBF firms should proactively plan with regulators and other financial institutions how to mitigate market risk in parallel with expanding small and medium sized businesses’ access to funding.
Inclusion
When it comes to inclusion, RBF firms face on a smaller scale the same broad challenge as the communities we operate in. How do we help restart the economy while addressing opportunity gaps that today leave some community members feeling disenfranchised? The RBF industry can be a force for good here, too.
Clearbanc and Founders First already stand out as models for how our firms can identify and fund women entrepreneurs and entrepreneurs from underrepresented communities. The need for such work is as pressing as ever. Despite meaningful efforts toward expanding financial inclusion and access to credit, women- and minority-owned businesses still struggle to access funding.
If another ‘Roaring Twenties’ awaits at the end of the pandemic, we should remember that the last century’s Roaring Twenties was not a time of plenty for everyone and that after a period of unchecked financial markets expansion, it preceded a period of want for most. Leaders of RBF firms should help promote an economic reopening that generates wealth and income beyond just the professional and geographic spheres that are familiar to us. To state the obvious: subscription SaaS and e-commerce businesses are not the only sectors of our economy; businesses in some industries or geographies lack the luxury of having dilutive growth equity investors to turn down; and we as financing providers should do all we can to support entrepreneurship across virtually all industries. In short, we should work to include as many revenue models, industries and geographies as we can in our funding programs so that the growth we make possible is enjoyed by a diverse mix of entrepreneurs, businesses and communities.
It’s true that, as currently constructed, the financing products we offer today won’t fit all businesses in all industries. Asset-intensive businesses with long cash conversion cycles and low margins, for instance, may not be able to qualify for or service debt under most RBF products in the market right now. But we should work to develop new ways of gathering data and payment information, evaluating risk and delivering capital to enable our financing products to work for more business models. We should also look to partner with other commercial financing providers — including what I hope will be a reanimated and nimble small business banking sector — to make available a wider range of financing products to small and medium sized businesses. That is how we embody inclusion as a shared value.
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There is a lot of work ahead for our country to revitalize our economy and help small business owners realize the American Dream. The financing needs of entrepreneurs are and will be immense enough for many RBF platforms to carve out niches, claim market share, and prosper. Today, at what feels like an important moment of awakening in and about our industry, let’s begin to work together to make sure we grow the right way.
