The pandemic has brought urgency to solving long-simmering problems with the way social enterprises are funded, especially those led by underserved entrepreneurs. We’ll need companies with community roots and strong social and environmental missions more than ever as we seek to build back a better, more equitable economy. One answer is revenue-based financing, an alternative funding structure that pays investors from future revenues.
Entrepreneurs often complain that venture capital leaves companies little room to maneuver and locks them into a rapid-growth-at-all-costs model. Social enterprise founders may not want to accept venture capital in exchange for ownership rights that could hamper their ability to pursue their mission. Meanwhile, early-stage investors may hesitate to take on substantial risk on companies that, to preserve mission, are less likely to offer investors traditional exits like takeovers and public offerings.
A report developed by the Toniic Institute through its Impact Terms Project (ITP), a library of alternative deal structures, found that alternative structures like revenue-based financing enable underserved entrepreneurs to raise the capital they need to fuel growth and attract additional investment. Revenue-based financing investments work with slower annual revenue growth and lower margins than traditional VC investments require, providing a jump-start to social enterprises and emerging market businesses while meeting investor needs.
Revenue-based financing allows investors to get returns even when the company is not planning an exit. Instead of getting paid out by new investors, as in an initial public offering, they receive payment from the company over time, which incentivizes them to help the company grow.
Revenue-based financing can be structured as debt or equity, depending in large part on local law, but either structure ties the investor’s returns to the company’s performance. The negotiated return is typically a multiple of the initial investment. The company pays investors a percentage of revenues until reaching a target return.
The faster the company pays money back, the better the investors’ internal rate of return. This has compelling advantages for the company: the timing and size of payments sync up with revenues; there is no dilution to ownership or control since investors don’t take equity or voting board seats; and the company is less likely to suffer a cash crunch.
The ITP team expected that lower minimum revenue growth rate targets would result in higher margin requirements. However, the study found that investment funds willing to accept low forecasted revenue growth in seed-stage companies also will accept low gross margins. Furthermore, they are sector agnostic and can fuel growth in a variety of industries and markets.
One case study in the ITP database shows how a Latin American company that makes environmentally friendly cleaning products benefited from revenue-based financing. The company had revenues and positive cash flow, but limited sales and marginal EBITDA, making valuation difficult.
Their investor, an impact fund focused on early-growth social and environmental companies, designed a revenue-based convertible loan to be repaid through an escalating percentage of sales over five years, with an 18-month grace period for principal and interest.
The equity-like structure aligned incentives while allowing the founders to retain ownership and control of its mission while capping the investor’s returns.
Investors see revenue-based financing as an instrument for the post-pandemic new normal. Adobe, a Mexico-based impact investing firm, recently made a handful of revenue-based financing investments to assist struggling social entrepreneurs in Latin America.
“One of the benefits we saw is that these instruments allow the cost of financing to be variable for the company,” said Paula Giraldo, investment officer at Adobe Capital, during a Toniic LatAm virtual panel on impact investing in Latin America, held in November 2020. She said that revenue-based financing also frees investors from performing up-front valuations, which are difficult to do fairly.
There are many alternative deal structures that balance the needs of investors and social entrepreneurs, and they can be highly tailored to the company’s situation. Both parties need practical guidance about all the options, while their lawyers and advisers need documentation to get comfortable with unfamiliar term sheets.
Toniic’s ITP hosts and maintains a free public database of tools including ready-to-use frameworks, definitions, term sheets and case studies to lower barriers for investors who want to fund solutions to our biggest problems and increase access to capital for early-stage enterprises. Take a look to find a tailored solution for your company—or to submit a new deal to help other social enterprises seeking solutions.
Image credit: Riccardo Annandale/Unsplash
John Berger, CFA is a finance, strategy, and operations professional adept at creating innovative solutions to complex problems with a focus on social enterprise and social capital markets. John brings a wealth of experience to Toniic that he puts to use both for Toniic Members and the public through programs like Toniic’s field building project ImpactTerms.org.