It comes as no surprise that revenue sharing agreements are popular financing instruments as far as startups are concerned. This is because it allows them to link their repayments to the amount of revenue that they generate. The relationship between revenue and repayment is directly proportional- the higher the revenue, the more the repayment and vice versa. This allows payments to ebb and flow based on how the business is doing at that particular point in time. Revenue based agreements are considered entrepreneur friendly, since they allow them to run their business on their own terms without having to compromise on ownership, which in turn leads to more sustainable growth.
REVENUE SHARING AGREEMENT VS. TRADITIONAL LOAN
From the legal point of view, a revenue sharing agreement operates in some ways like a promissory note through which the borrower is bound to pay a percentage of their revenue for a particular period of time until a pre-decided multiple is returned. However, it is not debt, nor is it equity.
Term Length: This refers to the amount of time by which the borrower has agreed to pay the full amount of the investment multiple back. Assuming the debt has not been repaid by the end of this period, then a lump sum payment (also known as a balloon payment) becomes due on the borrower.
Repayment Terms: These refer to the schedule of payments: how often do they need to be made? Terms vary according to the contract and payments can generally be made on a quarterly, bi-annual, or annual basis.
Revenue Percentage: This refers to the percentage of revenue that is to be given up by the borrower. The figure usually varies between 2-10%
Investment Multiple: This refers to the pre-determined amount an investor can expect to receive when the note is paid back in full. Investment multiples can range anywhere from 1.5 to 3x the principal amount. For example, if a business owner borrows $1000, and the investment multiple is 2.2, then he needs to pay back $2200 over the life of the note.
Minimum Payment: Some revenue sharing agreements include a minimum payment amount in order to secure their investors as well as to reduce the size of the balloon payment.
Securitization: To offer greater security to the investor, some revenue sharing investments might be protected by either the assets of the business or a personal guarantee from the business owner himself (though the latter is uncommon).
Payment Deferral Clause: Some agreements might include a payment deferral clause which gives companies the leeway of missing one payment without being considered to be in default.
WHAT COMPANIES BENEFIT FROM REVENUE FINANCING?
First off, a company must be generating revenue or on the verge of generating revenue in order to benefit from revenue financing. Companies experiencing moderate to high growth are best suited for revenue financing. Venture capitalists generally look for companies growing beyond 100% per annum. Since revenue-based financing is not dependent upon an equity-based exit, business owners can grow at a rate that is secure and sustainable. Therefore, companies with subscription-based models (SaaS companies) and high gross profit margins are great candidates for revenue financing due to their consistent stream of revenue and potential to scale.
PROS AND CONS OF REVENUE SHARING
One of the main reasons small businesses might look towards a revenue sharing agreement is because they may be at a stage where they are unable to meet the financial requirements of a traditional loan. If they meet the requirements of a traditional loan, then they might be tempted to go with that option if the loan amount and interest is less than the amount which they need to return under a revenue sharing agreement.
Even then, some might still opt for revenue sharing agreements if they need more money that they are approved for, or if they need less stringent payback terms.
Revenue sharing agreements offer some much-needed flexibility to startups who might initially find it hard to accurately predict revenue. Having a relatively lenient payback scheme helps get smaller businesses up and running faster, because they can focus on growing the business without the threat of debt crushing them. Some agreements might even have buyout clauses which allow borrowers to buy their lenders out by giving them the entire investment multiple and put an end to any further revenue sharing agreements.
Additionally, most revenue sharing agreements will not require personal guarantees, and business owners can rest easy in the knowledge that personal assets remain untouchable. From the point of view of investors, revenue sharing agreements provide a great opportunity to multiply their investment due to the attractive rates of return. They are also able to diversify their portfolio as a result of the recurrent payouts that they receive. The flip side is that there is a risk that the small business may never be able to pay them back, or that payouts would be delayed beyond the agreed upon time frame.
Another potential issue that lenders should look into has to do with what would happen if there were to be a change of control within the company, or if the company chose to go public. Since revenue sharing agreements might sometimes take the form of unsecured loans, there will be no guaranteed return of capital in the event of the issuing company's failure.
In conclusion, revenue sharing agreements have the distinct advantage of enabling small businesses to access a large amount of funds in a shorter span of time. Of course, it comes at the cost of a higher payback but given that the most common reason for small businesses failing is the paucity of funding, it is a trade-off that entrepreneurs happily accept.
For help with your revenue sharing agreement, contact The South Texas Business Lawyers!
Disclaimer: This article is made available for educational purposes only, to give you general information and a general understanding of the law, not to provide specific legal advice. By using this article, you understand and acknowledge that no attorney-client relationship is formed between you and The South Texas Business Lawyers, nor should any such relationship be implied. This article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.
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