Revenue Based Financing - aligning incentives
Building a Conscious Fund
Interestingly, I had worked on several revenue share financing deals while at Gray Matters Capital, building edLABS, a micro-impact VC fund investing in early-stage ventures in India. I always wondered why investors mainly use two instruments, i.e., equity and debt, to invest in SMEs and startups.
Unlike equity-based funding, revenue share financings provide entrepreneurs and businesses an alternative means to secure capital without giving up ownership or control of their company. Also, it is not like debt, in which there is a fixed payment schedule regardless of the business performance.
Revenue share financing involves an investor providing capital to a company in exchange for a percentage of the company's revenue over a specified period. The investor receives regular payments until a predetermined total payment amount, typically a multiple of the investment, is reached.
Is it also Sharia Complaint?
In an ideal scenario of revenue share financing with no fixed income, just profit-sharing based on actual company earnings, this structure could qualify as a Sharia complaint. Sharia-compliant financing adheres to Islamic ethical and legal principles, prohibiting certain practices such as charging interest (riba1) and engaging in speculative or uncertain transactions (gharar2).
Though not all revenue share financing is Sharia-complaint like in the below-mentioned scenarios (examples, not exhaustive list):
Conversion to Equity: In certain circumstances, such as a future fundraising round, the liability in revenue share financing can be converted into straight equity. This means the investor's stake in the company can transition from a debt-like instrument to an ownership position.
Capped (Minimum) Return: If an investor provides a $50,000 investment with a 3x minimum cap (floor), the total payback obligation would be $150,000. This cap sets a lower limit on the investor's return.
Residual Equity Position: Once the investment is fully repaid, the investor may retain a residual equity position in proportion to the initial investment. This means the investor can have an ongoing ownership stake in the company even after the revenue share financing arrangement has concluded.
Transparency and Halal Activities: The business operations should be transparent and by Sharia principles, avoiding activities that are prohibited (haram) in Islam, such as gambling, alcohol, etc.
Application in student debt
On the lines of revenue-based financing, I also see a huge potential for income share agreements to replace student debts, and several companies are cracking. I believe funds can also be structured to cater to student needs, where the outcome is aligned with the financing. A while back, I wrote a detailed piece on this3.
How to structure revenue share financing with self-liquidating (non-sharia complaint)?
Calm Company Fund4(previously called Earnest Capital)5 uses a form of note called the Shared Earnings Agreement (SEAL).
Return - decision tree for revenue-based financing
In revenue-based financing, there are three possible avenues for financial returns:
Exits: Investments that have been converted into equity can potentially yield returns through exits, such as initial public offerings (IPOs) or mergers and acquisitions (M&A) deals. These liquidity events allow investors to realize gains on their equity stakes in the businesses.
Capped Repayments: Investments that have not converted into equity can still provide returns through capped repayments on the principal amount. The repayment terms are structured to limit the total amount paid back, ensuring that the investor's returns are capped at a predetermined multiple of the original investment.
Residual Equity Positions: Investors may retain residual equity positions in businesses that have fully repaid the principal amount. These positions typically amount to around 10% of the initial capital invested. This residual equity allows investors to continue benefiting from the future growth and success of the business even after the initial investment has been repaid.
These three potential sources of financial returns in revenue-based financing offer diverse opportunities for investors, combining the prospects of exits, capped repayments, and ongoing ownership stakes to maximize their returns on investment.
If you want to understand how revenue share financing can perform in comparison, I highly recommend reading a piece by Toptal Talent Network Experts. In a scenario presented in this piece, the revenue-based portfolio would return 1.70x, which is 0.46x below the benchmarked returns given by a VC fund. The only upside over 3x received on the side of the revenue share portfolio is for the 10% residual equity positions that remain after principal repayments. Hence, residual equity positions become critical to have decent returns. There are other ways to increase return profiles, like capital recycling.
What do you think about Revenue Share Financing or Revenue Based Financing Funds? Why can not more lenders lend to SMEs that come with revenue-based financing structures rather than pure-play fixed debt? Why not more VCs align with business success instead of speculation?
I personally think we desperately need to align the incentives of investors with businesses that are not purely based on speculation.
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What Is Riba in Islam, and Why Is It Forbidden?, Investopedia