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When raising money through crowdfunding, one of the most important decisions entrepreneurs need to make is how to structure the offering. The appropriate structure will depend on a lot of factors, including the business’ stage of development, its performance to date, growth plans and the targeted capital source. But the options generally fall into one of two buckets: equity or debt. At Localstake, we’ve had success with revenue-sharing agreements, which are a form of debt, like a loan, but with variable payments that rise or fall with the business’ monthly revenue.
In this article we’ll explain how revenue-sharing works and compare it to alternative structures.
The key issue to address when building an offering structure is striking a balance between a business’ expected cash flow and growth plans and the target return for investors given the risk profile of the business. For any small or early stage business (and particularly those that don’t fit the venture growth trajectory) understanding how investors will achieve a return from a private offering can be difficult.
With equity, investors are typically reliant on the savvy of the management team to build a product and company in a dynamic market to the point that the company is an attractive acquisition target (or can secure enough financing to get to a size where an IPO is viable). This is a very difficult thing to do and dependent on many known and unknown variables. This profile typically leads to a binary outcome scenario for investors—either the entire investment is lost or they see a 20-30x return or higher.
Equity also brings complications, such as the addition of outside owners. Existing owners give up some ownership and have increased complexity in their ownership structure, reporting and corporate governance. This requires a level of sophistication and additional overhead from the team to manage the additional complexity appropriately.
For these reasons, equity can be an awkward fit for many Main Street businesses that don’t have venture growth trajectories.
A revenue share can be an interesting solution. In this structure, the business receives a loan from investors, and pays it back by sharing a percentage of its revenue in regular intervals until a target return has been achieved. That is particularly attractive for businesses with variable sales: when sales are good, you pay back more. In months when sales are slower, payments will be lower as well.
Revenue sharing removes the inherent complexity of equity, as the capital providers(s) are creditors to the business and not owners of the business. It also creates a very clear path of how the business will be generating return for investors.
Let’s look at an example scenario to illustrate how a revenue share loan works on the Localstake platform.
Company A is a restaurant that has been in business for 3 years with $850,000 in last 12 months revenue and an average annual growth rate of 7% percent—solid revenue to pay back a loan. It has a strong social media footprint and engagement, including an active review history with (mostly) good customer reviews and feedback.
The owner believes that the audience of customers and fans that the company has built represents a viable capital source and that many of its customers would be excited about participating in the growth they’re driving through their purchasing behavior. Company A is looking to update and improve its location, which will cost $200,000. The team expects the improvements to support continued growth of the business.
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Now let’s look at the basic parameters of a potential revenue share structure for Company A to finance the remodeling project. We’ll hold the next 12 months revenue flat from the previous 12 months and reduce the annual growth rate from the 7% historical growth to 5% expected growth. For this example, we’ll look at a 60-month term to pay the total obligation off and a total payback amount equal to 1.25x the amount raised (a fairly typical payback amount under revenue-share deals).
The cost of capital includes Localstake fees as well as the overall investor return paid out over the life of the offering. The return investors ultimately see depends on the speed at which the total payback amount is hit. If Company A does well and reaches the target payback multiple of 1.25 in 3.5 years, as it expects, the equivalent annual interest rate for investors would be 13%. If the company needs the full 60 months to pay the fixed amount, the equivalent annual interest rate would be 9.2%.
That sets up an incentive for investors to play an active role in the performance of their investment. By continuing their customer and advocate relationship with Company A, they are directly contributing to revenue performance and as a result, payment on the revenue share. In rate of return terms, Company A will pay a higher cost on the capital (albeit paying the same absolute amount in dollars) but they’ll benefit from stronger revenue growth and a more engaged customer base.
The cost of capital for the revenue share loan is higher than with an SBA loan and, most likely, other kinds of bank loans. That’s because there is no fixed payment and revenue share agreements are typically unsecured, meaning they are not backed by collateral. SBA loans are among the lowest cost of capital options around for companies, but very few qualify and the process can take several months.
The tradeoff for Company A is increased flexibility: with revenue sharing, when cash flow dips, financing expense also decreases. It also offers a unique way to engage a customer base and encourage them to increase their purchasing habits and general support of the business.
Localstake customer Beer Church Brewing is currently pursuing a revenue share offering using Regulation CF. To see an actual example of a revenue share, you can review the details of their offering, follow progress and invest at their Localstake page.
When comparing revenue share debt to more traditional forms of lending, a business must weigh the speed of underwriting, more flexible payments, an incentivized investor base, and no personal guarantee requirements. If these factors are attractive, then it could make sense to trade-off a higher overall cost of capital as compared to a traditional SBA loan.
This table highlights a basic comparison between features of a Localstake revenue share loan and an SBA loan.
Finding the right structure for a small business financing starts with a solid analysis of the business’ historical and expected performance. With a revenue share loan, the business and investors’ incentives are aligned to grow revenue and customer relationships. Both sides can contribute to that goal and ultimately drive a positive outcome for the business and investors via a simple and manageable investment structure.
Ryan Flynn is a cofounder of Localstake, a full service broker-dealer and crowdfunding platform that helps small businesses structure their securities offerings and connect with investors.
Disclosure: Localstake does not provide legal or tax advice. The information provided here is summary in nature and is not meant to cover a full analysis of securities laws. No information contained herein should be construed as advisory or to recommend a particular method of capital raising.