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The bright future of revenue-based financing

By Priyank Kothari, Director, Arvog

Revenue-based financing is a way to raise capital for a business by paying investors a percentage of the company’s ongoing gross revenue in return for their investment. Investors in an RBF investment receive a regular share of the company’s profits until a specified sum is repaid. This predetermined sum is generally a multiple of the initial investment.

From an investor’s perspective, revenue-based financing offers a chance to make a lot of money. However, since the recovery rate is directly related to revenue, an investor should be aware of the risks associated with the financing agreement. If the company’s revenue drops dramatically, the reimbursement rate will drop proportionally, immediately lowering the IRR.

Entrepreneurs and businesses can benefit from the RBF in various ways. However, the nature of RBF requires organizations to possess two crucial characteristics.

First, the business must generate revenue, as payments for the loan will be made from this revenue.

Second, the company’s gross margins must be high enough to cover the percentage of revenue spent on loan repayments.

The interests of RBF investors and the companies in which they invest are aligned. Both parties benefit when business revenue increases and both parties lose when revenue decreases. By offering revenue tracking reimbursement, RBF helps the business manage bad months.

When it comes to acquiring funds, the cost of capital is also a critical factor to consider. For a variety of reasons, the cost of capital in an RBF business is generally lower than in a comparable equity transaction.

For starters, the effective interest rate on the loan is well below the effective interest rate charged by an equity investor on their invested funds if the business is sold or additional funds are raised. Second, the legal fees for compliance and other regulatory checks are lower than raising equity funds. Finally, since investing is a form of debt, the interest paid on it is a tax-deductible expense for corporations.

With revenue-based finance still in its infancy in India, the timing couldn’t be better. More than 800 new-era brands have established themselves as successful e-commerce businesses in the country, using a direct-to-consumer method. Dozens of exciting new D2C companies and millions of small and medium-sized enterprises (SMEs) across the country have gone online over the past 18-24 months.

India has one of the largest start-up ecosystems in the world – the third to be exact – not counting the millions of SMEs about to embark on their digital journey. According to Avendus Capital, the direct-to-consumer market in India will be worth US$100 billion by 2025.

Due to a mix of variables, early stage start-ups or these SMEs are most suitable for RBF.

First and foremost, RBF platforms are ready to lend as little as ten lakh rupees and up to two crore rupees at a fee of 4-8% depending on the specified features. Second, rapid disbursement allows small businesses to obtain funds when needed. Third, knowing exactly how much of your income is needed to settle your debt in a given number of months is transparent. Finally, some platforms use a data-driven approach to provide funding focused on business fundamentals and performance rather than the people you know.

Although access to cash is quick, due diligence is not compromised. RBF’s fintech platforms leverage technology-driven procedures and unique data-driven underwriting algorithms to analyze companies and their performance. This also explains why RBF has so few NPAs.

The most significant development opportunity for RBF, however, comes from India’s booming D2C industry, which has seen tremendous growth throughout the pandemic. According to recent analysis by Inc42, while D2C companies saw an 88% increase in customer demand in 2020 over the previous year, only 25% of the $2 billion in funding over the past eight years went to D2C companies in the development stage.

The future of RBF in India is exciting and full of promise. RBF, as a revenue-driven and founder-friendly alternative, could be the extra stimulus India’s startup ecosystem needs to recover from COVID.