Revenue loans: New year, better math please
“If you are what you say you are, a superstar
Then have no fear, the camera's here
And the microphones
And they wanna know-oh-oh-oh, yeah ”
“Superstar” by Lupe Fiasco, 2007
The rise of revenue loans for startups has been a sign of the European venture ecosystem maturing in terms of more options for founders to consider when financing a startup (generally a good thing). These loans typically cost a 6-12% flat upfront fee and are marketed as ‘no-dilution and no-interest’ and can be used to fund marketing, inventory etc. This feels like a great marketing strategy given ‘you are what you say you are’ in the public realm, and ‘no-dilution and no-interest’ sounds compelling. Other Fintechs have used similar ploys, most notably Robinhood offering ‘no commission’ stock trading whilst monetizing its customers via payment-for-order flow (a practise that ‘smells bad’ according to Bill Gurley and is banned in the UK). Overall, my recent conversations with founders and VCs have left me thinking ‘no-dilution and no-interest’ revenue loans are misunderstood financing instruments and that their true end market is not VC-backed startups.
First, here’s some thinking on cost of capital — and why IRR and cash flow timing matters. A typical revenue loan from a European provider charges 6-12% flat fee upfront on the capital provided and is repaid by the borrower (i.e. startup) out of a revenue share agreement over around 6 months (according to my research). Modelling this out with a 6% upfront fee (lowest fee) in different scenarios backs into an IRR for the lender of 20-30% (my model below has 26%) and a cash-on-cash return of 1.06x.
Now this cash-on-cash return looks low (6% fee optically seems cheap) versus other sources of capital but the time cost of capital is quite high (26% IRR). Why? The revenue lender is repaid the full loan in 6 months, so capital is coming back very quickly which the lender can then use to deploy into other companies (in effect the lender is turning the capital multiple times across the year). The other benefit to the lender of this is that credit risk can be diversified across multiple companies if each € coming back is used to lend to another company.
So what does this mean for the startup? Yes it is true that this funding is non-dilutive and easy to implement but a 6% upfront fee is not apples-to-apples vs. a 6% annual interest rate, it is more akin to a 20-30% interest rate (i.e. IRR) given how quickly the capital repays. Within the wider context of venture returns, a typical venture capital fund at the early stage will seek >30% Gross IRR on investments over 5-10 years (i.e. 4-13x cash-on-cash return to make this IRR work across the fund life). Assuming most founders aim to be successful long-term at the point of raising early capital, this equity cost of capital is relatively similar to a ‘no dilution, no interest’ revenue loan (26% IRR in my model). The difference is cash flow timings; the equity cost may come in 5-10 years (and is conditional on success), the revenue loan will come in 6 months (regardless of success).
Other debt sources - A typical venture lending fund (full disclosure: my firm is predominately a venture lending fund) provides debt to high growth VC-backed startups that repays over 3-4 years at annual coupons of 10-12% and with a warrant to purchase shares (typically owning 1-2% of the company). The base IRR on an 11% coupon 3-year venture loan is 12.5%, with base cash-on-cash cost ~1.2x. Combining the lender’s warrants (1% dilution) and coupon (10%+) makes the deal look more expensive than a 6% upfront fee, but the venture loan remains with the startup for >6x longer duration than a revenue loan, so the capital can be properly invested and sticks to the balance sheet. If the warrants generate a 3x return in 5 years (i.e. startup is minimally viably successful), then the venture loan would cost 1.39x cash-on-cash and an IRR of 19%.
Other considerations – warrants make venture loans feel expensive but remember the venture lender is only making money on these instruments when other investors and typically when founders make money. As such there is long-term alignment with the team/investors vs a non-dilutive revenue loan where in any scenario the lender gets there 6% fee. Put differently, the revenue lender is agnostic to the Company’s long-term success, only attentive to their ability to survive over the next 6 months. I have been through exit processes with multiple startups and in most cases when the warrants are ‘in the money’ the other investors and management are ‘in the money’ and the mood is good.
Zooming out - what does this mean for startups? Management teams should look at both IRR and cash-on-cash of any source of capital they evaluate, not just headline figures. Revenue loans over 6 months at a 6% flat fee does not mean the cost of capital is 6%. Over a longer period of time, I think the ultimate utilisers of these revenue loans will be bootstrapped businesses who cannot get access to venture capital equity/venture loans given less ideal business models like ecommerce or lower growth profiles, so perhaps the 20-30% cost of capital for debt is a fair one for this risk profile. If I was running a high-growth startup I’d be tapping the equity and venture loan markets before revenue loan instruments, given the mixture of similar (sometimes lower) cost of capital and better long-term alignment (my investors, venture lender and I make money generally when the company is successful).
The investor perspective – all things being equal, revenue lenders are intriguing businesses as they can get equity-like returns (20-30% IRR+) whilst taking debt-like risk (senior to equity, highly diversified, liquid instruments as they are repaid daily/monthly etc). This reflects a very good conceptual risk-adjusted return with low downside and a nice yield (especially in a low interest rate environment like today). Revenue lenders also often connect into the payment processors of the startup so they sit in the payment flow (good position to be in credit-wise).
If I was an asset manager looking for a hedge against my long exposure to venture/technology, then these revenue loan businesses seem like a good idea; I think they should do well in a market downturn where venture capital tightens up and more startups will need funding of other sorts. Hedge funds in fact have been shorting the venture market for a while now, shorting stocks like SVB (largest bank for US/European startups) without much luck (stock up >300% in last 5 years); perhaps backing revenue lenders is the next rational idea if one believes in an impending downturn.
Sources: https://www.industryventures.com/the-venture-capital-risk-and-return-matrix/
