For entrepreneurs running companies intended to benefit society or the environment, traditional forms of growth financing often can be difficult to get.
That’s because investors that provide this financing generally expect a big pay-off when the company gets bought or goes public. But impact-oriented businesses aren’t typically attractive buyout candidates, and “a lot of impact entrepreneurs aren’t interested in selling out,” says John Berger, director, operations and impact solutions at Toniic, a network of impact investors.
It’s been a problem in the sector for companies seeking financing, but aren’t big or mature enough to attract traditional debt investors, and don’t have a business model that can create equity-like returns, Berger says.
The solution some companies are crafting with their investors centers on revenue-based financing, an old-school funding mechanism that has been rediscovered.
Essentially, revenue-based financing means companies and investors agree to share in an enterprise’s profits “without arguing over how expenses are allocated,” says Berger, who has worked with investors on these structures through the Impact Terms Project, a Toniic unit that shares innovations in impact investing terms and structures with entrepreneurs and investors.
It’s an approach that allows a business some leeway to deal with an unexpected revenue shortfall. As it happens, the economic upheaval caused by the Covid-19 crisis is testing this relatively new approach to impact investing, and in the end, should offer additional evidence of its strength as a financing mechanism for impact companies as well as other small businesses.
During a crisis such as the one caused by the spread of Covid-19, a company that utilizes traditional debt financing could easily default on a loan agreement as its sales falter. “Terms aren’t usually: ‘wait until things get better, and then we’ll talk,’” Berger says.
By contrast, revenue-based financing models include the potential for a business to face a sudden drop in sales. “If you have a couple bad months or bad quarters, it’s built in. You don’t owe as much back to the investors,” he says.
A Revenue-Based Approach to Private Financing
Rodrigo Villar, managing partner at New Ventures Group in Mexico, is utilizing a revenue-based financing model for investing in its second impact fund through the firm’s Adobe Capital subsidiary. This means companies in the US$30 million fund pay Adobe back each month based on a percentage of their revenue: If sales are good, the fund receives more money than if sales are bad.
Adobe’s strategy is to structure the deals as debt, although by utilizing an equity multiple. While this multiple can vary depending on the company, it tends to be around 2.5, Villar says. That means, if Adobe lends a company US$1 million, it expects to get back a percentage of the company’s revenue over time that equals US$2.5 million.
Adobe’s base-case scenario is to get this return-on-investment within about four years. That would provide the fund’s investors with an internal rate of return (IRR) of about 25% to 30%, he says. If a company does better than expected, it may be able to return the full US$2.5 million, in this example, within three years. That would mean an IRR closer to 35% or 40%.
But, if a company faces a drop in sales and it takes seven or eight years to return the money, the IRR can fall to 5.5% or 10%, he says.
Villar argues that “it’s common in traditional equity deals that you lose your entire investment.” But the companies that Adobe invests in rarely run out of cash, shut down, and deliver nothing back to investors. That’s because they are paying a percentage of their revenue often from the start, or soon after, so “in the worst case scenario, you still get some money back,” he says.
Resilience in Crisis
Adobe invests in companies in social-impact enterprises ranging from renewable energy, to affordable housing, and health care, focusing on leaders in their fields that are in a growth stage.
All of its investees are currently struggling because of the Covid-19 crisis, “but they are still paying,” Villar says. “Some are better-than-expected, some are under, but it’s a healthy portfolio—we still expect close to a 20% return.”
That’s because the structure naturally accounts for bad times as well as good. “We are assuming in those four or five years, there will be cycles, they will have downturns, but at the end [we] are getting the same multiple,” he says.
New Ventures recently extended the revenue-based financing concept into the lending market through another unit, Viwala. Like Adobe, Viwala focuses on companies seeking to make a positive social or environmental impact, but these are smaller, more traditional companies that need short-term loans. A typical loan is about US$75,000—which can be deployed in a week—versus Adobe’s $3 million or $4 million loans, which take three or four months to deploy.
Investors today are still in the “Covid-reaction” phase, but when they have time to reflect, Berger expects they will pay more attention to revenue structures.
“They will talk to other investors who will say, ‘I may have lost some return, but I didn’t get hurt as bad, and I still got my money back,’” Berger says. “That’s an attractive thing to hear during these times.”