Every now and then, something that has long existed gets rebranded. It’s presented as innovative, which technically it is, as it might improve the product or service incrementally or offer it in a different fashion. But the wheel hasn’t exactly been reinvented.
Such is the case with “revenue-based financing” in the world of SaaS. Many non-bank lenders portray the model as a way of lending that has never been done before—some, in fact, even say it isn’t a loan! But while the name is new, the underlying mechanics are anything but. Before being repackaged as revenue-based financing, this model of borrowing and lending was known as royalty-based finance, and common in industries such as life sciences where revenue streams are often very stable and based on monthly payments (just like in SaaS).
The way it works is fairly simple: A business borrows a certain amount, but unlike traditional term loans, their monthly payment is calculated as a percentage of their revenue. Let’s say, to use a simple example, that a SaaS company takes out a $10,000 loan, and agrees to payments equaling 5% of their revenue each month. If revenue in the first month is $50,000, their payment will be $2,500. Now let’s assume that revenue in the following month soars to $75,000. In this case, the monthly payment to the lender will be $3,750. The reverse is also, true, of course: Lower monthly revenue will result in a lower payment.
It’s easy to see the appeal of revenue-based financing. If your company’s revenue increases, odds are that your ability to service the loan should also rise. Meanwhile, if revenues decrease, monthly payments fall in tandem, easing pressures on your cash flow.
It all sounds very attractive, doesn’t it?
But before you rush to obtain a loan linked to your sales, there are some issues to be aware of. Long story short, revenue-based financing isn’t the panacea it’s often made out to be.
For one thing, if your sales rise after accepting the loan, your effective interest rate can end up being quite high. Imagine you borrow $30,000, and agree to ultimately pay $40,000 (the $30,000 principal plus $10,000 in interest). Many SaaS loans work in this fashion, with the borrower agreeing to repay a specified multiple of the loan. Perhaps you estimate that it will take you 3 years to repay the $30,000 in full. Assuming you’re right, our handy calculator tells us that your effective interest rate will be 19.752%.
One possibility, however, is that your sales skyrocket, and your monthly loan payments soar. Maybe rather than taking 3 years to repay your loan, it only takes you 1 year. You might think that’s a great thing. But in repaying the loan so quickly, our calculator shows that you will have paid an effective interest rate of 56.755%:
The key lesson here is one that revolves around the time value of money. Repaying a loan much quicker than anticipated results in a very high return for the lender, and a very high cost of capital for the borrower.
Understanding the Hidden Burden of Revenue-Based Financing
In addition to the potential for a very high effective interest rate, revenue-based financing presents complex challenges for SaaS businesses. While calculating the amount to be paid every month is straightforward, accounting for the payments can make your head spin.
According to the rules of accounting, each loan payment must be divided between interest and capital. With payments fluctuating each month, and the term of the loan uncertain, this can become very complex (indeed, we’ve seen auditors find the task difficult). Correctly dividing payments between interest and capital involves projections of the ultimate length of the loan, as well as assumptions about cash flows and a business’s internal rate of return. Especially for SaaS companies without finance specialists, revenue-based loans can be time-consuming headaches.
The Benefits of Revenue-Based Financing, Minus the Downsides
Here at Element, we do offer revenue-based finance but we also provide straightforward term loans for growing SaaS companies. We understand the allure of revenue-based financing, that’s why we’re happy to offer interest-only periods, so you can use more of your cash flow to invest in your growth at the beginning of the loan.
It’s the best of both worlds.
Looking for financing for your SaaS business or just have a question? Give us a shout. We’re always happy to chat.