Percentage of Revenue vs Fixed Payments

When thinking of a loan, many people will think of their home mortgage, which is usually a variable or fixed rate loan that gets paid back through pretty similar, consistent payments over the term.

A fixed payment schedule means the same amount is owed each period (typically one month). Variable rates mean the interest rate may increase or decrease from time to time. This variance is linked to a base rate, in the U.S. it’s usually the prime rate.

In the world of financing for growing SaaS companies, it is popular to take a variable monthly payment. A lender does this by linking the payment to a key indicator of success. Such indicators include:

  • Salaries
  • Profitability
  • Royalties
  • Revenue

The most commonly used of the list is taking a percentage of revenue to calculate the payment amount. Usually, the payment is between 2-15% of revenue.

However, the details can get a little fuzzy with the percentage of revenue payments. Some lenders choose to rely on revenue recognition, while others may take a percentage of receipts.

I.e. the amount a company has earned from business activities that month (revenue) vs the literal cash a company has received that month (receipts).

Why some prefer a percentage of revenue:

With this type of repayment, the percentage of revenue stays the same but as the company’s revenue grows, so does the dollar amount of each payment. Many borrowers appreciate the lower payments at the start of these loans. They’ll be able to pay less now and have more cash to grow their business in the short term.

If you’re doing $300,000 in monthly recurring revenue, you may look for a loan around $1m. At an interest rate of 18%, the payment would be $25,393 a month for a 5-year term. If you agree to pay 5% of revenue, your payment would start at only $15,000—around 60% of the fixed payment.

It’s not hard to see why an extra $10,000 a month would be attractive to a growing company, especially a company that wants to utilize that extra cash each month to grow.

However, in the event your company continues to grow, say from $300k to $800k, you’ll be paying $40k/mo and the loan will get repaid very quickly. This faster repayment doesn’t benefit you as the borrower, because it can restrict your cash flow more than necessary towards the end of the loan.

What happens with multiple pay-offs loans:

Many loans offered to SaaS companies today don’t use interest rates at all, but rather take a multiple repayment approach. If your company takes one of these loans using a percentage of revenue as repayments and grows more rapidly than expected, the effective interest rate could be astronomical when compared to a straight loan with amortization.

Example: You take a 5-year, 1.6x multiple repayment loan for $1m. That means you’ll need to repay the $1m principal as well as $600k in interest. If your company’s revenue increases such that you repay the loan in only three and a half years (42 months), your effective interest rate will be nearly: 29%

A flat interest rate loan of 20% would have cost you at most $521,832 in interest by month 42.*

($600,000 – $521,832) =  $78,168 increased cost of finance.

*Numbers are rounded and assume no prepayment penalties.

If a company doesn’t grow:

Some lenders choose to model the revenue over fewer years than the term.

I.e. calculating the loan repayment to 4 years of revenue on a 5 year term. This gives the company a year buffer to pay back the remainder of the loan. This makes the payment percentage higher.

The goal of this buffer is to allow any growing companies enough room to pay off the loan before the end of the term, even if their growth is a little lower than projections.

If the lender doesn’t leave a buffer or the revenue growth is not enough to repay the loan by the end of the term, you may be stuck with a bullet payment. We try our best to solve this problem when issuing loans with variable repayments.

Use our Percentage of Revenue Calculator to find what percentage of revenue your company would need to pay and what your loan would look like if your company doesn’t grow according to projections.

Fixed Payment Alternatives

A lot of borrowers think “lower payments for the first 2 years” and move on without considering the ramifications of the reduced capital for the rest of the term.

If lower starting payments appeals to you, there are options with a fixed payment schedule.

Many lenders will allow for an interest only period for up to 6 months. By allowing you to start with lower payments, interest only periods have a similar effect to the percentage of revenue method.

They give you both cash in the short term but also give you a clear forecast of your commitments.

At Element SaaS Finance, we offer both percentage of revenue and fixed schedule loans, but each company should consider their capital strategy over the entire term before making a final decision about which method is right for them.

We’re happy to help you however we can. Check out our tools for SaaS financing or contact us with any questions.

Elements of Finance

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