Revenue-Based Investing: Rethinking Capital Markets

We often associate the 2008 economic crisis with a period of sub-prime lending, which resulted in defaults once interest rates increased and homeowners were unable to make repayments. During the Great Depression and the Savings and Loan Crisis, businesses failed en masse, which led to them defaulting on their loans. We understand how these events occurred in a system of interest-bearing debt. We rarely, however, question the system itself. Could it be that it is inherently designed for exploitation and, ultimately, failure? Can we avoid the boom and bust cycles if we redesign our financial system to align the interests of all parties involved?

The powerful set the rules, and the rest accept – this is how it has been in the past, and it is how it is today. Arrangements of interest-bearing debt are designed from the point of view of the investor (the owner of capital), and by and large favour the investor. A business in need of cash, unwilling to give up ownership, will often resort to taking out a loan. The business then has to pay interest on the loan, either fixed or floating, each payment period, regardless of how the business is doing. With this setup, the investor (or loan issuer) is incentivized to extract the maximum return, even if this eventually runs the business into the ground; and if the business goes into bankruptcy before the loan is paid out, the debt holders have first dibs on the company’s assets to reimburse themselves. Clearly, the current system of interest-bearing loans does not align investor incentives with the interests of the business. Lenders do not have a stake in the success of the business in the way that shareholders do. This has proven to have disastrous effects on individual enterprise and on entire national and regional economies.

Enter revenue-based investing (RBI) – an innovative financing model that aligns investors’ interests with those of the businesses seeking funding. With RBI, investors receive a predefined percentage of the company’s monthly or quarterly revenues until a predetermined return multiple is achieved. The more successful the business is, the larger the investor’s return on investment (ROI); if the business is not profitable, the investor does not get paid.

The opportunity of Revenue-Based Investing

As already discussed, from a macroeconomic perspective, this mode of investing provides systemic stability, by incentivizing investors to make sound investment decisions that are not driven by a desire for short-term profits, but by fundamentals and a belief in businesses’ prospects. RBI, however, has additional benefits for companies and investors.

As with a traditional loan, RBI allows entrepreneurs to retain control of their business and avoid dilution. This permits founders to maintain the vision and direction of the business.

Unlike a traditional loan, RBI provides a flexible repayment plan, with lower payments when the business is going through a rough patch. RBI thus allows more companies to persist during economic downturns or company-specific events. From the investor perspective, RBI offers a built-in risk mitigation mechanism, as the likelihood of complete loss of capital is lower, given the lower probability of company failure. This flexibility also rewards talented investors, who can ascertain which companies will be profitable, with above-average returns.

Last but not least, RBI incentivizes companies to focus on revenue growth, which benefits both the business and investors. This can motivate cooperation between the providers and receivers of the funding beyond the provision of capital.

RBI and Islamic Finance

Islamic finance refers to those financial practices that are consistent with Sharia law. Despite their different origins, RBI and Islamic Finance share a common thread in ethical and sustainable investment methods. Islamic finance prohibits interest (riba) and emphasizes risk-sharing and asset-backed financing – all principals that align with RBI. One common Islamic finance instrument, for example, is the sukuk (Islamic bond), which offers returns generated from the underlying asset or project, rather than interest payments.

In areas of the world sensitive to Islamic law, RBI is gaining increasing popularity. In Malaysia, a hub for Islamic finance, innovative companies are leveraging RBI to offer Sharia-compliant investment products to investors looking to align their portfolios with their values. RBI thus plays a pivotal role in promoting financial inclusion and economic development.

Challenges of Revenue-Based Investing

RBI’s model, which is based on adjustable repayments with the increase or decline in a company’s revenue, presents a level of uncertainty for investor returns. Similarly for businesses, the potential volatility of repayment expenses may render RBI an unsuitable strategy for short-term financial planning.

Given the cap on investment returns with RBI, in the event of a company outperforming expectations (as with a unicorn), investor ROI would not reach the same levels as it would with an equity investment. Caps, however, can be negotiated at the outset.

Ultimately, RBI returns are not a sure thing. Investor success is tied to the success of the company they’re funding, so if the business fails, investors stand to lose the capital invested.

The road ahead for Revenue-Based Investing

Despite its currently small footprint, RBI’s landscape is expanding. A number of newly-emerged companies are creating innovative funding structures, tailored to different investees. Light Capital is a notable player, having pioneered a model for tech startups, and so is Clearco, whose focus is on e-commerce companies. Levenue and Viceversa are making strides in Europe. Those and many others, from Brazil to India, are transforming capital markets.

RBI is a game-changer in the venture capital ecosystem, offering an alternative to traditional equity and debt financing structures. It is a complementary option, broadening the funding landscape and making it more accessible for different types of businesses. Its flexibility, built-in risk mitigation, founder friendliness and cultural sensitivity makes RBI a tool that has the potential to drive innovation in previously underfunded industries and geographies.