The first decision that most business owners need to make when raising finance is whether to give away a portion of equity in their company, or temporarily introduce some debt to the business. However, many entrepreneurs will be unaware of a third type of business finance that sits between debt and equity financing, while offering the benefits of both.
Revenue-based financing allows businesses to ‘sell’ a portion of their revenue in exchange for an advance of capital. Rather than paying back a fixed amount each month, businesses share an agreed percentage of their daily or monthly sales with a lender until the advance, including interest, is paid off in full. This makes it an ideal solution for seasonal businesses, allowing them to pay back less when sales are lower and more when sales are higher.
Despite its advantages, however, business owners should consider the different types of revenue-based finance that are available, and how they compare to more conventional funding sources.
Merchant cash advance
One of the most recognised forms of revenue-based financing is the merchant cash advance, which lets businesses access funding in exchange for a portion of their credit or debit card sales.
Unlike a fixed-term loan, where a business has to regularly repay a set amount to the lender, a merchant cash advance company works directly with a business’s card terminal provider. Every time a business processes a sale with credit or debit card, a percentage of that sale is automatically taken by the lender, with the remaining balance going to the business. This continues until the advance, plus costs, is paid off in full.
Because repayments are tied to a company’s debit or credit card sales, many small businesses regard merchant cash advances as a more flexible form of finance than fixed-term business loans. Compared to a bank loan, they can also be agreed a lot quicker, as the lender is able to see how much a business makes in an average month by looking at their card transactions.
However, despite the speed and the flexibility offered by a merchant cash advance, it can be a more expensive funding option for small businesses. The fact that repayments are made with every card transaction means an advance is usually paid back relatively quickly, which can lead to a higher APR.
Businesses can also find it difficult to compare the cost of merchant cash advances with fixed-term business loans. While the price of loans is usually presented as a monthly interest rate, merchant cash advance companies tend to charge a ‘factor rate’, which is generally a figure between 1.1 and 1.5. This is multiplied by the advance amount to give the total amount repayable. So, if a company agrees to an advance of £10,000 on a factor rate of 1.4, the total amount repayable will be £14,000.
Many business owners won’t know how a factor rate converts to a monthly interest rate. This means they could agree to a merchant cash advance, even though there might be cheaper options available. By using a rate comparison tool, business owners can compare quotes from lenders that present their costs in different ways, to ensure that they get the possible deal for the business.
A small number of lenders offer a finance solution that combines elements of a merchant cash advance with the key features of a conventional business loan.
Instead of being tied to a company’s credit or debit card income, a revenue advance offers a capital uplift in exchange for a share of total turnover. This makes it a good option for businesses that take payments in several ways, including bank transfers and issuing invoices to customers.
A revenue advance offers the same flexibility as a merchant cash advance, with repayments aligned to the amount of turnover made by a company in a given time period. This means a business can grow at its own pace, without having to worry about repaying a fixed lump sum on a regular basis.
However, unlike a merchant cash advance, which can see companies making weekly or daily repayments, businesses only need to make one payment per month with a revenue advance. This can make it easier to forecast and manage monthly cashflow. Dealing directly with the lender, as opposed to a card terminal provider, also offers greater visibility and control over repayments.
Of course, the funding solution that suits one business might not be the ideal fit for another. But, thanks to revenue-based financing, small businesses have another viable alternative when it comes to financing their growth.
Peter Tuvey is co-founder and managing partner of Fleximize.