If you’re a business owner or startup founder, you might make raising capital for your enterprise a top priority.
For a business searching for capital, there are many possibilities available. A business may sell equity to angel funds, venture capitalists, or other categories of private investors. Businesses with recurrent income can choose revenue-based financing. Additionally, businesses can apply for various sorts of credit from lending organizations including banks and NBFCs.
A lot of entrepreneurs may be confused about the best way to finance their company’s operations.
In this article, we will cover a detailed comparison between revenue-based financing and term loans to help you choose between the two.
What is Revenue-Based Financing?
Revenue-based financing, as the term suggests, means borrowing based on your company’s revenue. You can use your company’s ongoing revenue (which is an asset of your company) and avail yourself of credit by providing a percentage of that revenue as collateral. Essentially, you are borrowing against your business’s future revenue.
The future revenue will be calculated based on the current revenue of your company and the general trend of the market in which your company operates. For example, if your company is in an emerging technology field, you may be able to borrow a higher amount assuming a high growth rate.
What is a Term Loan?
A term loan is what people generally understand when they use the word “loan”. A term loan is essentially credit that needs to be paid back over a fixed amount of time along with interest. The “term” of a term loan can range anywhere from a few days to several years. Because the term of the loan is pre-fixed at the time of borrowing, it is called a term loan.
The term loan interest rate can be fixed or floating. Usually, companies prefer to borrow at a fixed rate so they can be certain of the amount that they need to repay the lending institution.
Also Read: 7 Best Ways to Get Funds for Your Business
Comparison Between Revenue-Based Financing and Term Loans
There are essentially three factors to consider when deciding whether to opt for revenue-based financing (RBF) or a term loan.
Risk Associated with Each Type of Loan
- As mentioned earlier, the amount that you can borrow through RBF depends on the future revenue of your business.
- Generally, the assumption is that your company will grow over time, so you can borrow a higher amount based on that assumption. However, this can also be a risk factor when you avail such financing. You will need to ensure that the revenue of your company keeps growing according to or faster than the projections made at the time of availing the financing.
- In case your company’s growth slows, stops, or reverses, you may be in a difficult position and need to refinance at a higher interest rate.
- In the case of term loans, you will need to pay a fixed amount throughout the tenure of your loan. Because the amount is consistent each month, the monthly amount during the initial period of availing of the loan may be higher when compared to an RBF.
- A term loan becomes relatively more cost-effective over time in case your company grows and your ability to service the loan improves.
The Impact on Cash Flow
- The impact on cash flow is different when you compare RBF and term loans. When you avail of an RBF, your monthly payments usually increase over time in keeping with growing revenue. In contrast, when you avail of a term loan, you usually have a fixed amount that needs to be paid each month.
- For a business, this means that their cash flow remains steady when they opt for RBF. This is because the payments that need to be made are relative to the revenue that the business is earning. For a term loan, the monthly payment remains the same throughout the tenure of the loan, which means that you will be paying a higher percentage of your revenue at the start of the loan compared to the tail-end of the loan period.
- Hence, a company needs to choose between higher payments upfront (under a term loan) or higher payments later (under revenue-based financing).
- However, some lenders also offer interest-only payments during the initial few months of the term loan. Hence, you have the flexibility of choosing this type of term loan if you need a few months before you start making full payments.
Also Read: A Guide To Apply for MSME Loan Online
The Interest Rate
- The primary difference between an RBF and a term loan is the term of repayment. Under an RBF, there is no fixed timeline within which you need to repay the loan. This also leads to the cost of the capital varying significantly. If the period is longer, the cost of the loan can go up a lot more over time when compared to a shorter term.
- In contrast, a term loan has a fixed period for repayment. Hence, the borrower can calculate their exact liability at the time of availing the loan, which leads to better predictability of the repayment outgo. There are several EMI calculators available online that you can use to calculate your term loan interest. Further, your lender will provide an amortization schedule which will provide the exact breakdown of your monthly payments.
- Overall, the total cost of capital is usually higher for RBF when compared with term loans. However, the advantage that RBF has over term loans is that the former is more flexible when it comes to repayment and gives more headroom to businesses.
Wrapping Up
Revenue-based financing and term loans both have their pros and cons. The decision to choose between the two should be based solely on the needs of your company.
If your company prefers the ability to make flexible payments that come at a higher cost, RBF may be the better option for you. However, if you want fixed term loan interest rates at a lower cost, opting for a term loan may be the right option.
