If you’re a business owner or start-up founder, raising money for
your company may be a priority for you.
There are several options
out there for a company looking for funding. A company can sell its
equity to venture capitalists, angel funds, or other types of private
investors. Companies that have recurring revenue can opt for
revenue-based financing. Further, companies can avail of different
types of credit from lending institutions like banks and NBFCs.
A lot of entrepreneurs may be confused about the best way to finance
their company’s operations.
In this article, we will cover a
detailed comparison between revenue-based financing and term loans to
help you choose between the two.
What is Revenue-Based Financing?
Revenue-based financing, as the term suggests, means borrowing
based on your company’s revenue. You can use your company’s ongoing
revenue (which is an asset of your company) and avail yourself of
credit by providing a percentage of that revenue as collateral.
Essentially, you are borrowing against your business’s future
revenue.
The future revenue will be calculated based on the
current revenue of your company and the general trend of the market in
which your company operates. For example, if your company is in an
emerging technology field, you may be able to borrow a higher amount
assuming a high growth rate.
What is a Term Loan?
A term loan is what people generally understand when they use the
word “loan”. A term loan is essentially credit that needs to be paid
back over a fixed amount of time along with interest. The “term” of a
term loan can range anywhere from a few days to several years. Because
the term of the loan is pre-fixed at the time of borrowing, it is
called a term loan.
The term loan interest
rate can be fixed or floating. Usually, companies prefer to borrow
at a fixed rate so they can be certain of the amount that they need to
repay the lending institution.
Also Read: 7 Best Ways to Get Funds for Your Business
Comparison Between Revenue-Based Financing and Term Loans
There are essentially three factors to consider when deciding whether to opt for revenue-based financing (RBF) or a term loan.
Risk Associated with Each Type of Loan
As mentioned earlier, the amount that you can borrow through RBF
depends on the future revenue of your business.
Generally, the
assumption is that your company will grow over time, so you can borrow
a higher amount based on that assumption. However, this can also be a
risk factor when you avail such financing. You will need to ensure
that the revenue of your company keeps growing according to or faster
than the projections made at the time of availing the financing.
In case your company’s growth slows, stops, or reverses, you may be in
a difficult position and need to refinance at a higher interest
rate.
In the case of term loans, you will need to pay a fixed
amount throughout the tenure of your loan. Because the amount is
consistent each month, the monthly amount during the initial period of
availing of the loan may be higher when compared to an RBF.
A
term loan becomes relatively more cost-effective over time in case
your company grows and your ability to service the loan improves.
The Impact on Cash Flow
The impact on cash flow is different when you compare RBF and
term loans. When you avail of an RBF, your monthly payments usually
increase over time in keeping with growing revenue. In contrast, when
you avail of a term loan, you usually have a fixed amount that needs
to be paid each month.
For a business, this means that their cash
flow remains steady when they opt for RBF. This is because the
payments that need to be made are relative to the revenue that the
business is earning. For a term loan, the monthly payment remains the
same throughout the tenure of the loan, which means that you will be
paying a higher percentage of your revenue at the start of the loan
compared to the tail-end of the loan period.
Hence, a company
needs to choose between higher payments upfront (under a term loan) or
higher payments later (under revenue-based financing).
However,
some lenders also offer interest-only payments during the initial few
months of the term loan. Hence, you have the flexibility of choosing
this type of term loan if you need a few months before you start
making full payments.
Also Read: A Guide To Apply for MSME Loan Online
The Interest Rate
The primary difference between an RBF and a term loan is the term
of repayment. Under an RBF, there is no fixed timeline within which
you need to repay the loan. This also leads to the cost of the capital
varying significantly. If the period is longer, the cost of the loan
can go up a lot more over time when compared to a shorter term.
In contrast, a term loan has a fixed period for repayment. Hence, the
borrower can calculate their exact liability at the time of availing
the loan, which leads to better predictability of the repayment outgo.
There are several EMI
calculators available online that you can use to calculate your
term loan interest. Further, your lender will provide an amortization
schedule which will provide the exact breakdown of your monthly
payments.
Overall, the total cost of capital is usually higher
for RBF when compared with term loans. However, the advantage that RBF
has over term loans is that the former is more flexible when it comes
to repayment and gives more headroom to businesses.
Wrapping Up
Revenue-based financing and term loans both have their pros and
cons. The decision to choose between the two should be based solely on
the needs of your company.
If your company prefers the ability to
make flexible payments that come at a higher cost, RBF may be the
better option for you. However, if you want fixed term loan interest
rates at a lower cost, opting for a term loan may be the right option.
