Deciding whether a company needs revenue-based financing or term loans while looking for venture debt can be a challenging task. Revenue-based financing (also known as royalty-based financing) is a method of raising funds where investors agree to provide capital to a business against a certain percentage of a company’s ongoing total gross revenue. On the other hand, a term loan refers to a financing option where lenders provide a lump sum amount of cash upfront against specific borrowing terms.
Businesspersons who are stuck between these two financing options can compare the costs, advantages, and risks to take the right decision. Therefore, before delving deep into the comparisons, business persons must know the cost of capital. Take a look.
Cost Of Capital
For instance, a company has taken revenue-based financing of Rs.10 lakh at a 2.2X repayment multiple. Here, the company pays 7% revenue each month with a target term limit of five years. On the basis of growth, a company can repay early. However, regardless of the term limit, a company has to pay 12 lakh for the borrowed money.
On the other hand, if a company opts for a term loan of Rs.10 lakh using amortization, the repayment amount can be evaluated initially depending on the term.
Due to the significant cost differences, it is recommended to compare revenue-based financing and term loan on the basis of three prime factors: interest rate, the risk involved, and cash flow impact. Let’s focus on these factors minutely.
- Comparison On The Basis Of Interest Rates
The term limit of revenue-based financing is unknown. Hence, the total borrowing cost in the case of revenue-based financing varies significantly. Subsequently, calculating an effective interest rate is difficult as business persons do not know when to pay back the borrowed amount.
Here, tools such as Excel or calculators can help business persons greatly. To calculate the amount, business persons need to enter the loan amount, amount to be repaid, and an estimated term to get revenue based loan interest rate. Once business persons find out an effective interest rate of RBF, they can compare it with the type of different term loans and interest rates available to them.
Businesspersons will find that the interest rate is much higher than term loans. Term loans are offered for a longer duration and can be fixed or floating depending on the type of interest chosen. However, they must remember that royalty-based financing comes with repayment flexibility which is a much-needed criterion for small businesses.
- Comparison On The Basis Of Risk Involved
In revenue-based financing, the business needs to grow continually to repay the loan amount at the end of the targeted term limit. If businesses stop growing, they will not be able to repay as there will be an outstanding amount at the expected term that will need refinancing. Businesspersons must remember that refinancing can be a costly affair.
On the other hand, fixed-rate loans reduce the risk of borrowing as the company will be able to pay the fixed payment once it gains traction. Here, the loan becomes self-financing where it can repay easily through the growth in revenue. However, as the revenue increases, it can put stress on cash flow.
In case of a term loan, the high interest rate and credit score penalties and the hazardous cycle can compel individuals to look for other financing options.
- Comparison On The Basis Of Cash Flow Impact
In revenue-based financing, the payments of the initial year will not be higher as a company will not grow enough to make high payments as that of a term loan. However, as the company makes progress, the payment will increase, limiting the benefit from the increased revenue.
On the other hand, term loans that come with a fixed interest rate can ensure a steady payment throughout the course of tenure. Also, here, the payment will be much higher than revenue-based loans. As a consequence, this financing option does not necessarily suit the reason for taking the loan for growth purposes.
There can be some financial institutions that will allow an interest payment for a term loan. This will ensure cash flow benefits like revenue-based financing by enabling reduced payment at the early stage of the loan term.
Businesspersons looking for a simple credit facility can get the same in an online marketplace like the MANDII app. Here, business persons can easily get funding facilities almost instantly without any hassle. Further, the app helps borrowers to select financial institutions as per their suitability and avoid interacting with multiple financiers.
While term loans ensure limited total loan cost, revenue-based financing guarantees capital without losing company share. Both these credit options have advantages as well as drawbacks; hence, while choosing between these two borrowing options, individuals must identify their business credit needs, other business demands and financial stature to make an informed decision.