Jim Verdonik founder of Innovate Capital Law
Capital Talks are a series of conversations Jim Verdonik is having with interesting people about anything he wants to talk about.
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In this session Jim Verdonik talks with Benji Jones talk about:
WHY INVESTORS AND BUSINESSES MAY NOT LOVE REVENUE SHARE LOANS
BENJI: Jim, in our last discussion about Revenue Share loans, we gave a pretty flattering description of Revenue Share loans. Two lawyers can’t talk about this without talking about the downside. Go ahead. Spoil the party. What are the problems with Revenue Share loans?
JIM: Like anything that sounds too good to be true, sometimes it is. Here are the issues you need to watch out for – reasons you might not to LOVE Rev Share:
- Repayments can slow a business’ ability to reinvest in long-term growth compared to equity.
- Slower revenue growth may mean a lower sale price at exit (if that’s what the business owners are looking for).
- Paying investors is an ongoing expense and can be headache, unless you hire someone do it like a payroll service.
- Paying investors also requires sharing periodic revenue numbers with many people. This info may leak to competitors and customers.
- In an LLC or other pass through entity, owners will be taxed on phantom profits used to repay the loans. That’s not a problem with equity.
- Future lenders may be unwilling to make new loans to the company while the Rev Share debt is outstanding.
JIM: Benji, don’t make me do all the hard stuff. It’s your turn.
BENJI: OK, I still LOVE Rev Share, but raising capital through investment crowdfunding is complicated. Businesses need to be prepared for added regulatory and compliance costs, as well as the distractions that accompany taking investments from a “crowd” of people. Management still has a responsibility to provide information and respond to these investors, even if they are not “owners” of the business. In addition, businesses raising capital through Rev Share loans will need to manage the payout process carefully.
JIM: What about investors?
BENJI: Investors should recognize that there are always risks associated with any kind of investment – particularly investments in small businesses and startups. There is no guarantee that the business you love will actually continue to operate successfully or derive sufficient revenue to repay your loan.
JIM: Can you talk some more about what investors should consider before investing?
BENJI: Many of the things that might be appealing for companies about Rev Share loans cut the other way for investors. For instance, unlike equity, Rev Share investors don’t have any voting, economic or management interest in the business. Although they are creditors, they typically don’t benefit from personal guarantees, security interests, financial covenants, or other restrictions that protect banks or institutional investors. Rev Share loans are often junior to other loans the business has now or may obtain in the future. That means that other lenders may get paid while Rev Share loans remain unpaid. This risk of junior debt is why Revenue Share loans offer higher interest rates than banks typically charge.
JIM: Are there any other reasons investors should be cautious?
BENJI: Although Rev Share loans offer the opportunity to support the businesses you care most about – investors should consider all of the terms being offered by the company and all the facts the company discloses, including whether the company is generating revenue, to minimize your risk of not getting paid back and maximize your expected return. It is critical to understand the terms that govern an investment before you commit.
JIM: What’s the best way for investors to deal with these risks?
BENJI: Diversification. Don’t invest too much of your capital in any single business or in any single type of deal.
JIM: So, are you advising investors to LOVE Rev Share loans in moderation?
BENJI: Yes. Too much of anything can be bad for you. Revenue Share loans are no different.
JIM: What about taxes?
BENJI: Rev Share has a more complex tax impact than say, straight debt or equity, due to the variable nature of the installment payments. Businesses and investors alike will need to understand how tax payments and paperwork will be handled post-closing. (Many platforms, like Streetwise and LocalStake, offer post-closing payment services to help companies manage these hurdles.) You should consult your personal tax, accounting and legal advisors before making an investment.
JIM: Do you have any parting advice for potential Rev Share issuers and investors?
BENJI: I’ll tell them the same thing my Mother told me growing up. It always started like this:
Before you get “hitched” . . . and ended with a tragic story.
JIM: Sounds like you have the makings of a country-western song there.
BENJI: There’s a lot of drama in raising capital. So, why not? Of course, LOVING Rev Share when you plan your deal is a lot like getting married. Most people are in LOVE when it starts, but how long the LOVE lasts is what counts. Having a long lasting LOVE of Rev Share depends on whether your projections were realistic and how you manage your business. So, be careful your LOVE affair with Rev Share doesn’t end in a messy divorce.
This is Jim Verdonik signing off until our next Capital Talk.
This article is one of a series of three articles that discuss Revenue Share Loans in detail. You can find our other two articles at:
Loving Revenue Share Loans
Crunching Revenue Share Loan Numbers
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