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Revenue-Based Financing: Changing the Game of Small Business Lending

Manage Your Money
by Vince Calio12 minutes / April 3, 2024
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How revenue-based financing is changing small business lending

For small business owners, getting the capital you need through a bank loan to maintain and grow your business can be a lengthy and difficult process, especially over the past two years as interest rates continue to rise and traditional banks have tightened their lending requirements as a result. Small business loan applicants must have excellent credit and a strong cash flow to even be considered for a loan. 

There are, however, certain financing products that have risen to prominence that allow small business owners access to working capital without having to face difficult requirements, give up equity in their business, or fill out lengthy paperwork. One of those products is revenue-based financing, an alternative way to get funds based on your business’s future revenue.

What is Revenue-Based Financing?

Revenue-based financing – sometimes referred to as sales-based or royalty-based financing – is a unique funding method in which a financing “fronts” a lump sum of cash to a small business in exchange for a predetermined percentage, or “factor” of that business’ future sales. In essence, the financing company is purchasing a business’s future sales at a discounted rate.

Let’s say that a financial institution, typically an alternative lender, fronts $100,000 in a revenue-based financing deal to a small business with a factor rate of 1.2. That means that, over time, the business owner will pay 20% of their sales on a daily, weekly or monthly basis back to the financing company until $120,000 has been paid off. There is no set date for when the payments end, they only end until the owed amount has been paid. 

Unlike a traditional small business loan which requires fixed payments, there are no fixed monthly payments in a revenue-based financing arrangement. If sales go down, the factor rate won’t change, but the amount being paid back will go down since you’re paying a percentage of your sales to pay back the “fronted” amount.

Why and When Revenue-Based Financing is Needed

Since revenue-based financing is more expensive than a loan or line of credit, it is not for everyone. If you’re seeking to invest in the long-term growth of your business by adding more space, increasing inventory, or hiring additional staff, then a bank loan is a very good financing tool if you qualify. 

Revenue-based financing, however, is a great form of financing when you need cash quickly for immediate expenses, short-term growth targets and emergencies. While it is more expensive than a bank loan, it is also easier to qualify for if your business has a strong sales history or can otherwise demonstrate the ability to produce future sales. Generally, you want to make sure your small business is making enough in sales to remain profitable under the terms of a revenue-based financing agreement. Also, since the approval for revenue-based financing is largely dependent on sales history, the financing company will typically place less weight on your personal credit during the underwriting process. 

Here are just a few examples of when businesses could use revenue-based financing:

  • A small construction company is awarded a large contract but needs cash quickly to purchase inventory and hire additional workers. That small business can receive $700,000 through revenue-based financing to fulfill the obligations set in the contract. If the contract is worth $2 million and the company has a factor rate of 1.2 and must pay back $840,000, the revenue-based financing deal would be well worth it, especially if the construction company does not qualify for a bank loan or line of credit.
  • A small, two-year-old retail store borrowed money from investors when it launched and has produced $250,000 in annual sales. That business needs cash to expand but doesn’t want to dilute its earnings with additional investors. Since most lenders would reject an application for a bank loan from a company that’s only two years old, that small business owner can borrow $50,000 through a revenue-based financing deal and use those funds for immediate expansion, while slowly paying back the money through increased sales due to expansion.
  • A small software firm is seeking to quickly develop and launch a new product that is expected to increase sales by 20%. However, the owner does not want to pull capital away from other units to pay for the $250,000 in marketing, research, and development that it will take to launch the new product. With a revenue-based financing deal, the firm can get those funds quickly, and the sales of the new product will exceed the cost of capital in the revenue-based financing deal.

Essentially, the rule of thumb for revenue-based financing use is that the cost of the funds you receive in the agreement should be covered by the growth opportunity you are funding while still giving you profit.  The idea being that, without the funding, you would not have been able to move forward with your project and would have lost all of that potential revenue. 

How is Revenue-Based Financing Different from a Loan?

While revenue-based financing does front your business money, it differs significantly from a traditional business loan. The most significant differences are:

Easier to obtain.

The biggest difference between a loan and a revenue-based financing deal is accessibility. Obtaining revenue-based financing is substantially easier than obtaining a loan. A bank loan usually requires:

  1. A good to excellent credit score;
  2. Several years in business;
  3. A strong cash flow; 
  4. In some cases, a business plan presentation, and
  5. A compelling plan on how you will use the proceeds of the loan.

The qualifications for revenue-based financing, however, are considerably less since this form of financing relies heavily on the strength of your sales. When you apply for revenue-based financing, you will often only need:

  1. A fair credit score in the mid-600s, depending on the lender;
  2. Typically two years in business, and
  3. A strong sales history. 

No default risk.

With a traditional loan, you must pay back the borrowed amount with interest over a predetermined period. If you fail to make your payments in that confined time frame, you will default on your loan. With revenue-based financing, you don’t have this same risk of defaulting. Instead, you will keep paying the pre-agreed-upon percentage of your future sales until the money that’s been fronted to you is paid back. If sales are low, your payment amount is smaller.  If sales are great, your payment amount is larger.

Quicker funding.

Loans from traditional lenders often take time to obtain – sometimes weeks – especially if you’re trying to get a SBA 7(a) loan. Revenue-based financing is typically offered by alternative lenders and non-bank financing companies and requires less paperwork than traditional lenders. In the case of revenue-based financing, the application is far simpler than for a loan, and funding can come in as little as 24 hours. 

Revenue-based financing is more expensive.

While revenue-based financing has some unique advantages over traditional loans, small businesses must keep in mind that generally, factor rates are more expensive than an interest rate on a loan, so it’s important to carefully weigh the pros and cons of each before deciding on the type of financing to apply for. 

Revenue-Based Financing is Changing the Lending Landscape

Data indicates that with the advent of alternative lenders (the predominant financial institutions that offer revenue-based financing), this type of funding has changed the landscape of the small business lending market over the past 15 years. While revenue-based financing has been available to small business owners for the past two decades, it has gained massive popularity as an alternative financing source for small business owners who need funding quickly and may not have all of the qualifications for a loan or do not have the time required to wait on approval for a small business loan.

During periods over the past 15 years when loan requirements from traditional banks tighten and bank loans become harder to obtain, revenue-based has soared in popularity. According to the Federal Reserve of St. Louis, in 2010, two years after the Great Recession, the volume of revenue-based financing grew to $524 million – nearly double the amount from three years prior.  According to a study conducted by Benziga Research, the global revenue-based financing market size was valued at $2.8 billion in 2022 and is forecasted to grow to $4.9 billion by 2028. 

Economic Woes Bolster Revenue Based Financing

Rising interest rates since March 2022 coupled with rising inflation since the end of the COVID-19 pandemic, caused the cost of capital on bank loans to skyrocket and traditional banks to demand higher borrowing standards such as excellent credit scores and higher cash flows than in the past. 

According to the Federal Reserve, applications by small businesses for bank loans and lines of credit decreased from 89% in 2020 to 72% in 2022. Approvals for loans and lines of credit dropped to 68% in 2023 from 76% in 2020. In the Federal Reserve’s latest study, 10% of small businesses that applied for financing in 2022 sought revenue-based financing. That figure was up from 8% in 2020 – when interest rates were very low – and 9% from 2019.

Additionally, approval rates on small business loans and lines of credit have decreased dramatically, making an alternative lending option such as revenue-based financing all the more attractive. Approval rates by traditional banks were 83% in 2019, the year before the COVID-19 pandemic, and fell to 68% at the end of 2022. 

Pros and Cons of Revenue-Based Financing

As much as revenue-based financing can be an extremely valuable financing tool, it must be emphasized that this type of funding isn’t for everyone nor for every situation, as it’s more expensive than a traditional bank loan and line of credit. However, while bank loans and lines of credit are excellent financing tools, they often carry high borrowing requirements and, therefore, may be difficult to obtain for some small businesses. 

Revenue-based financing is a great funding tool under the right circumstances, but it does have potential downsides. It’s extremely important for any small business owner to closely examine the pros and cons of revenue-based financing before choosing this as a financing option. 

Pros of Revenue-Based Financing

  • Revenue-based financing is easier to obtain than a loan or line of credit. Since the main requirement is a strong sales history, you don’t need an excellent credit score or three years in business to obtain revenue-based financing.
  • There is no default risk since payments are based on a factor of future sales.
  • Business owners don’t have to give up equity to obtain revenue-based financing like they would with private equity.
  • revenue-based financing is a good way to boost your short-term cash flow without having to meet the often stringent requirements of bank loans or lines of credit. 

Cons of Revenue-Based Financing

  • revenue-based financing is more expensive than a loan. Depending upon the strength of your sales and your credit rating, the cost of capital can be significantly higher than a loan or line of credit. 
  • In a typical revenue-based financing arrangement, the payments you make are variable and based upon how strong your sales are. Therefore, if sales are slow, the payment arrangement can last for an extended period of time. 
  • You may get rejected for revenue-based financing funding if you don’t have a strong sales history. 
  • You need a strong cash flow to obtain revenue-based financing funding. For bank loans, most lenders will closely examine your cash flow to see if you qualify. Revenue-based financing providers mostly focus on your sales history. Therefore, if you have high monthly expenses and don’t adjust them to make a revenue-based financing arrangement, your business could lose money since you are giving up a percentage of your sales in a revenue-based financing deal.  

How to Obtain Revenue-Based Financing

Alternative lenders that operate mostly online offer revenue-based financing funding, so a quick online search can give you an expansive list of providers. Reputable revenue-based financing providers do have requirements for obtaining this form of funding, including

  1. A credit score in the mid-600s
  2. 2 years in business, and
  3. At least $250,000 in annual revenue.

Watch out for Bad Actors

Some states are tightening regulations surrounding revenue-based financing, but it remains a loosely regulated industry. Therefore, when searching for a revenue-based financing provider, you may come across some predatory financing companies that are claiming to be legitimate. When researching alternative financial institutions that do offer revenue-based financing, here are some of the signs you should look for that may indicate a “bad actor”:

  • It will offer you funding despite a very low FICO score (under 600).
  • It does not have bonafide customer reviews.
  • It does not offer strong customer service or is difficult to reach.
  • It will try to rush a deal before carefully going over specific terms with you.
  • It will try to downplay or gloss over abusive terms of funding, such as exorbitantly high factor rates and transaction fees.
  • The lender’s history in business is obscure or difficult to research.

Consult a Small Business Financing Specialist

Many reputable financing companies offer small business financing specialists who can assist you in deciding whether revenue-based financing is a good option for your business, and you should work closely with them. The main thing to do is to examine whether you will be using the funding to increase your profits to the point that you can pay the factor rate and still be profitable. 

You should also go over the timeliness of receiving funding – are you in need of cash right away and have a strong sales history, or are you seeking to borrow funds for long-term growth? Does your sales history justify a revenue-based financing arrangement? Finally, like with any financing product, you need to go over the specific terms of repayment to make sure you can comfortably afford them. 

 

Vince Calio

Vince Calio

Content Writer
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Vince Calio has been a writer for Kapitus since 2021. Before that, he spent three years operating a dry-cleaning store in Rahway, NJ that he inherited before selling the business, so he’s familiar with the challenges of operating a small business. Prior to that, Vince spent 14 years as both a financial journalist and content writer, most notably with Institutional Investor News and Crain Communications.

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How a Line of Credit Works for a Small Business

Manage Your Money
by Vince Calio8 minutes / April 3, 2024
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How does a small business line of credit work?

Various financing products can help small businesses with specific needs, but few of them are as versatile as a business line of credit. Some of the terms of a line of credit can be confusing, however, so knowing how they work will be key to maximizing its use to benefit your small business and evaluating whether a one is the best option for your business. 

It’s also just as important to know the exact terms of a line of credit so you can compare lenders and know beforehand if you’re comfortable with the fees and repayment requirements that come along with a business line of credit, as those terms differ considerably from other types of financing, such as bank loans and even business credit cards. 

What is a Business Line of Credit?

A business line of credit gives you access to a credit line that you can use whenever you need it and to spend on whatever business expense you see fit. You only pay interest on the amount you’ve borrowed for your business. Often, a line of credit is used to cover short-term business expenses in between payment periods; but it can also be used for any other business expenses, such as handling growth opportunities, and some financing companies even allow business lines of credit to be used in making small real estate purchases, depending on the credit limit. 

Business lines of credit are issued directly by traditional banks, credit unions, and some specialized online lenders, while alternative lenders and small business brokers typically offer lines of credit through a marketplace – a group of lenders that the alternative lenders and brokers have partnered with that will make competing offers for your business. 

Also, lines of credit tend to charge a variable rate on the amount you borrow, while a term loan typically charges a fixed rate. Similar to loans, however, lenders and financing companies will base the interest rate on your FICO and business credit scores, as well as other factors. 

Business lines of credit are very different from other forms of financing: 

  • Business lines of credit differ from term loans because with a term loan, you are receiving a lump sum of cash for a specific purpose that often must be approved by the lender, and you must start making payments on a loan with interest almost immediately.
  • Also, while a business line of credit is conceptually similar to a business credit card in that it provides a line of credit that can be drawn upon, it has very different repayment terms and fees than a credit card. While you can draw a limited amount of cash from a business credit card, that cash usually must be paid back at an extremely high interest rate.
  • Lenders charge a variable interest rate on the amount you draw upon from a business line of credit, which is typically the prime rate plus several percentage points. The interest rate is typically higher than a term loan, but remember, with a term loan you must pay interest on the entire amount of the loan, whereas with a line of credit you only pay interest on the amount borrowed.

What are the Typical Fees of a Business Line of Credit?

For an unsecured business line of credit (one that does not have to be backed by collateral or a personal guarantee), there are fees and repayment terms that differ from most other forms of financing. Some of the fees may be waived if you take out a secured line of credit.

These main fees include:

Origination fee.

The origination fee can be up to 2% of the total line of credit, but may be waived by some financing companies if you have a past relationship with the lender or your credit is exceptional. 

Maintenance/non-usage fee.  

The maintenance fee is typically charged monthly or annually in order to keep your line of credit open, and can be up to 2% of the total line of credit. It is often charged if you have a business line of credit but don’t draw upon it for long periods of time.

Draw fee.

Some financing companies and lenders may charge you a fee every time you draw upon your line of credit. This fee will depend upon the relationship you have with your lender, as many traditional banks and alternative lenders are willing to waive this fee.

Annual fee. 

Many lenders will waive this fee, especially if you are a long-time customer. It is usually a small, flat fee, often of up to $200, depending on the lender. 

What are the Conditions of a Business Line of Credit?

Lines of credit have very different repayment and withdrawal terms than term loans and business credit cards and should be a major factor when considering whether you want to take one on. Before you agree to take on a line of credit, you need to carefully consider the terms and shop around for a deal that best suits your small business. 

Some of the most common conditions you can expect are:

Somewhat stringent requirements.

Getting approved for a business line of credit is tougher than getting approved for a business credit card, but slightly easier than a business loan. When you apply for a line of credit, most financing companies require good-to-excellent FICO and business credit scores, a minimum annual revenue and a minimum time in business, often at least two years. You must also have a strong cash flow, and if you have borderline credit scores, some may require a personal guarantee and collateral, which includes any high-value assets you may own. 

Minimum withdrawal amounts.

Most financing companies require a minimum withdrawal amount when you tap into your line of credit, often $5,000. Additionally, with some providers, it may take up to 24 hours to obtain those funds once you’ve requested them. Unlike a business credit card which can be used for small purchases of specific items, lines of credit should be used for larger business expenses such as payroll or additional inventory. 

Pre-scheduled repayments.

Repayment terms of a business line of credit are more stringent than those of a loan or a business credit card. Depending on the terms you agree to with the financing company or lender, you may be required to make weekly or monthly payments once you’ve borrowed against your line of credit. You also may be required to pay off your balance in full on an annual or sometimes monthly basis, depending on your credit agreement.

Renewal schedule.

Most providers require you to renew your line of credit at various intervals, often on an annual basis.

How Can Businesses Use a Line of Credit?

The benefits of a business line of credit are many, mainly because you can use oen for any business expense you wish. That doesn’t mean, however, that you shouldn’t be judicious in how you spend the money that you borrow against your line of credit. Generally, lines of credit can be used for:

Seasonal operating expenses.

A business line of credit can smooth out your cash flow by covering expenses such as payroll, inventory and rent during your small business’ offseason, or to cover short-term expenses when you’re waiting for a batch of invoices to be paid or if there’s a sudden slowdown in the economy. 

Marketing tools.

Your business may offer the best products and services in the world, but it won’t do you any good if nobody knows about them. Getting the word out about your business usually requires a strong, multi-front marketing effort. This may include online and social media advertising, a well-optimized website and email campaigns. These services take time and effort and aren’t cheap, especially if you decide to outsource them. This is where a business line of credit can be very handy. 

Handling big contracts.  

Landing a big contract, especially a government contract, is always exciting for your small business. A business line of credit can help you conveniently purchase the inventory and resources you will need to handle that contract and strengthen your business’ reputation.

New product development.

Your business likely can’t grow without offering new products or services, but developing and marketing those new products can be costly. A business line of credit can help you meet the expenses required to bring a new product or service to market and grow your business. 

Get the Business Line of Credit That’s Right for you

There are many lenders and financing companies that offer business lines of credit in both the traditional and online space, but they all have different requirements and different terms. If you are considering taking out a line of credit, make sure you check with several different providers and compare. Each provider will offer different credit line amounts, different rates and varying repayment terms and fees. Make sure you obtain the line of credit with the requirements that are right for you and your business.

Vince Calio

Vince Calio

Content Writer
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Vince Calio has been a writer for Kapitus since 2021. Before that, he spent three years operating a dry-cleaning store in Rahway, NJ that he inherited before selling the business, so he’s familiar with the challenges of operating a small business. Prior to that, Vince spent 14 years as both a financial journalist and content writer, most notably with Institutional Investor News and Crain Communications.

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https://kapitus.com/wp-content/uploads/2024/04/How-a-Line-of-Credit-Works-for-Small-Business.jpg 1500 2250 Vince Calio https://kapitus.com/wp-content/uploads/2024/01/Kapitus_Logo_white-220.webp Vince Calio2024-04-03 01:38:512024-04-07 18:52:38How a Line of Credit Works for a Small Business
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