If you’re researching financing options for your small business, then you may come across a lesser-known option called revenue-based financing. As the name suggests, this type of alternative financing is based on your business’s future revenues rather than your financial history.
While revenue-based financing can provide quick cash in a pinch, you need to consider its long-term impact on your business finances before you say “yes.”
Here, you’ll learn the basics of revenue-based financing and the pros and cons of the most common types. You can also explore other financing options for small businesses with flexible eligibility and approval criteria that offer more stability and benefits.
What is revenue-based financing?
Revenue-based financing is a type of alternative financing that’s based on the future revenue of your business. This is different from debt-based financing (such as small business loans) or equity-based financing (where you sell a percentage of business ownership for investment) because it’s looking at projections rather than what’s already happened in your business.
Two of the most common types of revenue-based financing are:
1. Merchant cash advance
This type of financing is most often available to small businesses that have a history of receiving revenue through debit and/or credit card transactions.
With a merchant cash advance, your business receives a lump-sum payment from a financer in exchange for a portion of the revenue from future debit and credit card transactions. Terms are established with the financer and include a repayment cap, which is a percentage of the loan (the factor rate) added to the principal.
In addition, the financer will take a certain percentage of every transaction paid by debit cards and credit cards, known as the holdback. The repayment term for a merchant cash advance is brief, usually 1 to 2 years. The advance is considered paid in full when you’ve repaid the total amount of the repayment cap and any fees.
Pros:
- Merchant cash advances can be relatively easy to get. If your business has an established history of credit and debit card payments, it could be eligible.
- You only repay the advance when transactions go through. If your business is cyclical, merchant cash advances can help you repay more during your high season and less during your low season.
- They can help with working capital and occasional cash-flow shortfalls
- There’s no collateral required
Cons:
While merchant cash advances can be helpful, they can also be a tool for predatory lending. Financers can charge high percentages for the factor and holdback rates, which can make advances expensive and difficult to repay.
Here’s a typical scenario (without applicable fees):
Cash advance: $100,000
Factor rate: 1.4
Total advance: $100,000 x 1.4 = $140,000
Holdback: 20% of each debit or credit card transaction
Length of time to repay the advance if you generate $50,000 in sales each month:
$50,000 x .2 (20% holdback) = $10,000/month = 14 months
It’s worth noting that in this example, the equivalent annual percentage rate (APR) would be 34% if this was a loan – and many merchant cash advances have even higher APRs.
Also, because they aren’t reported to credit agencies, this type of financing won’t build your credit history.
2. Invoice factoring
Invoice factoring is another type of revenue-based financing that’s also referred to as invoice financing or accounts-receivable financing. It’s primarily available to small businesses that operate in the business-to-business (B2B) sector.
With this financing, your business sells its outstanding invoices (your accounts receivable) at a discount to a third party in exchange for a lump sum of cash. After the third party collects on the invoice, they reimburse you the difference, minus any applicable fees.
Pros:
- The process is quick and relatively easy
- You receive funds in a lump sum payment
- It can help with working capital and occasional cash-flow shortfalls
- There’s no collateral required
Cons:
What seems like a straightforward solution can be expensive and lead to further cash-flow challenges. Let’s look at an example:
- You invoice your customer. You sell your products to another business, creating a $10,000 invoice.
- You sell your invoice to a factoring company. The factoring company agrees to buy your invoice and advance you 85% of the total value minus a 2% upfront fee, or $8,300.
- The factoring company assumes responsibility for your invoice. They receive the repayment from your customer in 60 days.
- The factoring company charges fees. They charge a 1% factor fee for every 10 days it takes your customer to pay the invoice. If your customer pays in 60 days, your fee will be 6% of $10,000, or $600.
- The factoring company sends you the remaining balance, minus fees. Now that your customer has paid, the factoring company will send you the remaining 15% of the invoice amount, or $1,500, minus the $600 fee. You’ll receive a total of $900 back. This means at the end of the process, you’ve received $9,200 out of the total invoice amount of $10,000. If this was a loan, the approximate APR would be 42.35%.
Better financing solutions for small businesses
The key to securing financing with good terms is to find the right lender with the right loan for you. Here are several available to small businesses in all stages, including. options for quick financing and a tremendous range of business uses and industries:
- Loans from Community Development Financing Institutions (CDFIs): CDFIs are community-based, government-certified organizations, like Pursuit, that often work with underserved communities and business owners that need more flexible terms. CDFIs offer a range of financing options for needs like working capital, invetory, equipment, and more. Many also offer programs through the U.S. Small Business Administration (SBA), like the SBA Microloan.
- Business line of credit: A business line of credit is a revolving credit line that can be drawn as needed up to a predetermined credit limit. You only pay interest on the amount you’ve borrowed and the credit becomes available again once repayments are made. This gives you flexibility in managing your business’s cash flow. Business lines of credit are available through banks, credit unions, and other lending institutions.
- Family and friends: These are often first-line loans because borrowing from personal contacts can be an accessible and affordable financing option. These are especially beneficial if your business is in the pre-launch or early startup phases. If you go this route, it’s essential to establish clear terms and expectations to maintain healthy relationships.
- Crowdfunding: Online crowdfunding platforms allow you to gain support from numerous small investors or supporters in exchange for rewards, equity, or debt. This can be a way to raise capital without taking on traditional debt.
- Peer-to-peer lending: This is when funds are borrowed from several individual investors through online platforms that match borrowers with lenders.
Pursuit can support your business’s success
If your business is experiencing a cash crunch it may be tempting to turn to merchant cash advances and invoice factoring to cover the gap, but there are better funding options to keep your business growing. By working with Pursuit, you can access more than 15 business loan programs that are designed with small business owners like you in mind.
When you’re ready to learn more, reach out to us to learn how we can work together to move your business forward.
