A 20 year old software company was working to develop some exciting new products. Management had scoped out its future features and functions and shared their solution concepts with potential customers who showed strong interest. The challenge was it would cost the company $1 million beyond their free cash flow to complete the product within a year.
Venture capital route
Wanting to accelerate its time to market, the Company decided to explore raising capital with venture capital (VC) funds. After all, this was a mature software company that was already generating annual revenues of $7 million. It had a real track record, operating history and straight forward growth plan.
During their discussions, VCs showed initial interest but then faced a challenge. That challenge was the Company’s existing debt. Over the years, management had funded it growth by raising debt from local investors, family and friends. Most of the capital was in the form of a 5-year, interest-only notes at annual interest rates of between 11% and 13%. These investors were so happy with those interest rate returns, management was able to raise $6.8M. The VCs however, didn’t want to provide growth capital and ‘sit behind’ or subordinate to these loans. If they were going to invest, they’d want to pay off all this debt. This meant that what started off as a $1-$2M capital investment was now going to be a $8 million investment. Additionally, the VCs valued the Company at approximately $15 million which meant if they invested the $8M million they’d likely have a 50% or higher ownership stake in the Company. Management and its owners wanted the extra $1M of capital but they didn’t want to give up control of their business in process.
A better solution
Thankfully a better capital solution came along in the form of Revenue Based Financing (RBF). A relatively new debt product, Revenue based financing provides upfront capital similar to an equity investment or term loan but rather than take equity shares in the business or have a fixed debt payment, the repayment of the capital is based on a fixed percentage of future revenues over the term of the loan. In this case the term was 5 years and the Company’s fixed payment was 2% of monthly revenues. So, basically if the Company performed as expected and made payments over the term, they’d pay back the principal plus the fund’s target return.
This product offered the Company several key benefits over equity or other debt solutions. In comparison to equity, RBF takes no ownership stake in the business and has no governance requirement so the existing owners didn’t get diluted or give up control. In comparison to debt, there is no fixed payment, no financial covenants (meaning they can’t default based on a ratio) and no personal guarantees.
Using this approach, the Company secured $1.5M of revenue based financing to accelerate development of its new products. In addition, the Company did not have to pay off its existing debt and didn’t dilute its ownership.
Within three years of securing its capital, the Company grew annual revenues from $7M to $13M. At that time the Company then went back to the capital markets and secured $12M of capital at a post money valuation of $35M. With this capital the company was able to pay off all existing debt holders, secure $5 million of new growth capital while still retaining 2/3rdof its ownership in the company.
Where they are today
Today, the business is generating annual revenues of over $20 million and management estimates its enterprise value to be over $65 million. This implies the Company’s equity value for the original owners and investors is over $40 million.
While it’s true the real drivers of the business are the management team, the quality of its products and meeting the unmet needs of its customers, this financial outcome wouldn’t have happened without revenue based financing.