Determining whether a company requires revenue-based financing or business loans while seeking venture debt can be difficult. Revenue-based financing (also known as premium financing) is a way of raising funds. The buyers agree to lend money to companies in exchange for a share of the company’s ongoing total gross revenue. But on the other hand, a business loan is a type of financing in which lenders provide a lump sum of cash upfront in exchange for specific borrowing terms.
The business that is shred between such two financing options can weigh the costs, benefits, and risks to make the best decision. As a result, before going deeper into the comparisons, business owners must first understand the cost of capital.
- Cost of capital
For example, a company has received Rs.10 crore in revenue-based financing with a debt payment multiple of 2.2X. In this case, the company will pay 7% of monthly revenue with a five-year term limit.
A company can repay early based on its growth. Irrespective of the time frame, a company must pay 12 lakh for borrowed funds. But on the other hand, a company decides a business loan of Rs.10 lakh with payback; the repayment quantity can be calculated at the outset based on the term.
Because of the major cost variations, revenue-based financing and business loans are recommended to be compared using three primary criteria: rate of interest, associated risk, and working capital impact. Let’s take a closer look at these elements.
- Comparing both based on the rate of interest revenue based financing or business loans:
The maximum term for revenue-based financing seems to be unidentified. As a result, in the case of revenue-based funding, the overall cost of borrowing money varies significantly. As a result, calculating an effective interest rate is difficult because business owners do not recognize when to repay the borrowed amount.
Tools like Excel and spreadsheets can be extremely useful in this situation. To get a revenue-based loan interest rate, the business owner must enter the loan balance, the amount to be reimbursed, and an estimated term. Once a businessman has determined the effective interest rate of RBF, they can compare it to the various business loans and interest rates available to them.
A business owner will discover that perhaps the interest rate is considerably higher than those of business loans. Whereas the business loans are available for a more extended period and can be fixed or floating in nature, depending on the type of interest chosen, it must remember that royalty-based financing provides debt payment versatility, which is necessary for smaller businesses companies.
- Comparing both based on risk involvement:
In revenue-based financing, the business must keep growing to repay the loan balance at the time of the term limit. If a company stops growing, it will be unable to pay back as there will be a remaining amount at the expected term that will require refinancing.
Repayment can be an expensive process for business owners. On the other hand, the business loans decrease the risk of borrowing because the company will pay the fixed payment once it gains purchase.
The loan has become self-financing at this point, and it can be quickly repaid due to revenue growth. However, as revenue grows, it can strain cash inflows.
- Comparing both based on cash flow impact:
The payouts during the first year of revenue-based financing will be lower because the company will not have grown sufficiently to make the high payouts required by a business loan.
However, as the company advances, the payment will rise, restricting the advantage of increased revenue. At the same time, business loans can guarantee a consistent payment throughout the term.
Furthermore, the payout will become much more significant than with revenue-based loans. As a result, this financing option does not always correspond to the reason to take out the loan in the first place.
A few more financial companies may allow an interest charge on a business loan. This will ensure cash flow benefits similar to revenue-based financing.
Conclusion: Each of these credit choices has benefits and disadvantages. Therefore, when deciding between any of these two lending options, individuals must consider their business credit needs, other business requirements, and financial situation is needed to make an accurate choice.