Revenue-based financing or equity funding?
For most businesses looking for funding, there are generally two broad options available: debt or equity.
Businesses in the UK tend to be averse to borrowing and, as traditional debt hasn’t typically been an option for fast-growth (or loss making) e-commerce businesses, most choose the equity option and fundraise.
However, given the rapid growth of revenue-based financing (RBF), it’s a good time to rethink those options. RBF lenders have seen a steady rise since 2005, with 32 US firms managing around 57 funds representing an estimated $4.3bn in capital, according to a TechCrunch report from last year.
Daniel Lipinski, CEO and founder of Outfund, told SiliconRepublic.com in a recent interview that the rise in e-commerce enabled “a new wave of businesses” to get capital that it couldn’t get before using the familiar merchant cash advance business model that was well established in the US.
“RBF is literally just taking a merchant cash advance and utilising payment processes, open banking and modern APIs to pull data and get information about that business to make a lending decision. That’s essentially how it emerged from the old world to the new,” he said. (Silicone Republic, What does Clearco’s retraction mean for revenue-based financing? Sept 2022)
Here, we’ll look at how the two options differ, the true cost of both and what other benefits they bring, helping you make a better-informed decision when it comes to funding your growth.
Equity funding for e-commerce businesses
While equity funding is a great option (angel funding or venture capital) for fast-growth businesses, it can be distracting for founders as it takes a lot of time to pull together the right information, find the right investors and negotiate a term sheet. However, the straight cash injection without short or medium-term repayments is attractive, and so is the additional support mechanism. However, you will lose some control and equity of your business in the process.
Advantages and disadvantages of equity financing
- Investors bring a wealth of experience to help your business grow.
- Equity investors tend not to rely on credit scores to make investment decisions.
- You won’t need to repay the funding (in the short-term) which helps with cashflow.
- The investor group will have partial ownership of your business, it could dilute your control, ownership and speed of decision-making.
- Any dilution will impact your exit value.
- The process of equity funding can be time-consuming and distracting from growth.
Debt financing for e-commerce businesses
Debt is debt, meaning it needs to be repaid at some point. However, unlike equity funding, you’re not inviting others into your cap table or Board room so when the debt (and interest) is paid back, your liability, and relationship with them, is over. In recent years, we’ve seen a meteoric rise in the availability of revenue-based financing for e-commerce businesses through lenders such as Outfund, Uncapped, Pipe, Wayflyer or marketplaces such as Capitalise.
Many of the advantages and disadvantages of equity funding are flipped for debt funding.
What is revenue-based financing?
Similar to a merchant cash advance in the physical retail space, revenue-based financing is a method of debt funding from lenders who take a percentage of ongoing sales transactions from the business until the original loan (and interest) has been repaid.
Example repayment structure which fluctuates with revenue (source: Uncapped)
Key assumptions (source: Uncapped)
How revenue-based financing works
Investors use clever bits of kit to look at Google Analytics to see what your cost per acquisition is. They look at your sales metrics from the likes of Shopify, Amazon and eBay. They try to get a sense of your cost per acquisition at the front-end, either through social media or PPC. Then at the back-end, they will look at what you're selling, what your margins are and your average monthly revenue.
The great thing about this type of financing is that it’s intrinsically linked to the amount of monthly revenues that are coming through your stores, and therefore, it's relatively scalable.
Unlike traditional debt instruments, the lender is getting paid back in increments on every single transaction made from day one, which makes it attractive (and less risky) to lenders, even with fast-growth, loss-making e-commerce brands. As revenues grow, you can either become more self-sufficient, or continue to accelerate growth by renewing the facility but based on your new revenue numbers.
Advantages and disadvantages of revenue-based financing
- It’s affordable as it’s based on your monthly revenue. So, if you have a poor performing month, your monthly repayment will reflect that.
- Despite the apparently high APR, it’s typically more cost effective than giving away equity.
- Once the debt has been repaid there doesn’t need to be any further relationship.
- Lenders don’t have control or influence over the company, so you can maintain ownership and direction.
- The amount you’re able to borrow through revenue-based financing is generally lower than through equity funding.
- Revenue-based financing is repayable, which adversely affects monthly cashflow, whereas equity funding isn’t.
- It’s a relatively short-term debt instrument which can impact confidence in medium and long-term planning.
Is revenue-based financing cheaper than equity?
Most people in the UK are predisposed to not borrow from a business perspective. If you fall in that camp, 10% to 40% APR on revenue-based financing feels very expensive. You’ll probably be thinking ‘Ouch, I'm not going to do this’.
While 10% - 40% looks expensive, it could well be a lot cheaper in the long run than equity.
Example revenue-based financing v equity funding:
Ownership impact of £1m revenue based financing v equity funding
Key assumptions (source: Uncapped)
For the purposes of this example, we’ve excluded:
- Deal costs e.g. legal and other professional fees.
- Management time costs.
Top tips for getting funding in the next 12 months
As equity funding is tightening up, revenue-based financing will become even more attractive to e-commerce brands looking to grow. Here are some top tips if you’re considering revenue-based financing.
1. Take on debt carefully
As with any financing, you need to do your homework before taking on any debt. Justin Langen from Uncapped explains it this way, “The market for revenue-based financing is still very new and constantly evolving. At this point in time the rates available to businesses are increasingly attractive. From an Uncapped perspective, it’s cheaper than it’s ever been to secure a debt line. However, you have to understand what you can afford, like any consumer would. It is important to take into account potential future cashflow restraints that may affect the business later down the line. In turn, it is the role of the responsible lender to only ever offer you debt that is clearly serviceable by your business’ current metrics.”
2. Have a longer runway for debt financing
Justin goes on to say, “I would encourage businesses to approach debt with long term planning in mind from the outset. If you’re approaching a lender with three months of runway remaining in search of a 12-month loan, it is unlikely you are going to achieve your desired outcome. Taking on debt should be approached proactively rather than reactively, it’s not a last resort or emergency capital. If a company with 12 months of runway and a company with three months of runway compared their offers from lenders, the difference would clearly illustrate the value of retaining a healthy cash reserve. This is true for the rate, term and amount. Being proactive and forward-planning for debt gives the lender confidence that they will be paid back. The more hard data you can show them to prove that they will recoup their investment, the more likely you are to get to the amount, price and term that you are hoping for.“
3. Have clear visibility and metrics on the acquisition side
In order to get the funding you need, you must understand everything about your business. Understand which channels are selling well, what is the value of your product from the cost of purchase through the cost of goods, distribution and ultimately what your net margin is out the other side.
4. Understanding your cashflow needs
Portfolio CFO and e-commerce leader at flinder, Fatima Salhab reiterated the importance of looking ahead with a robust cashflow forecast. Your cashflow forecast needs to be built properly with a P&L, balance sheet and cashflow that are all interconnected. You need to be realistic with your assumptions and discuss these across the business – finance may drive the forecast, but the business needs to both input into it, and buy into it. Rather than seen as a finance exercise, it can be used as a wider business discussion tool to break down components of growth and set goals. Once you’ve modelled out various scenarios and got funding, use it to monitor performance and dissect where the business is digressing from plan to make operational improvements.
As mentioned in previous articles, there are a number of metrics as an e-commerce business you need to know. If you are thinking, ‘I don't know what my CAC and LTV are’, then you may not be in the best place to take on this type of financing as a replacement of equity.
Whatever funding option you choose, be sure to research it thoroughly before applying. And remember that raising capital for your start-up comes with risks. Carefully consider taking either on carefully and understand the impact on your business today, and in the future.