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.
Viewer discretion is advised.
In this session Jim Verdonik talks with Benji Jones about: CRUNCHING REVENUE SHARE LOAN NUMBERS
BENJI: Jim, We’ve already discussed the general positives and negatives of Revenue Share Loans, but we’ve forgotten one important thing.
JIM: What’s that?
BENJI: The numbers. How do people know the Revenue Share loan numbers work for them and their business?
BENJI: Before you start talking numbers, let’s do a short recap on how a Revenue Share Loans work.
BENJI: A revenue share is a loan that is paid back over time by the borrower “sharing” a percentage of its “revenue” at regular intervals until it has returned to the lender a fixed multiple of the amount loaned. The percentage of revenue the business pays can vary widely based on projected revenue and operating profit.
JIM: How long are the loans?
BENJI: The business’ repayment obligation might be open ended (meaning the loan remains outstanding until the stated return is met without a final due date), but more often the payback amount must be repaid in full within a specific time window (say 3 to 5 years). Having a definite end date may require the business to make a “balloon payment” at the end of that period if the monthly or quarterly revenue percentage repayments are less that the total payback amount. BENJI: Are there any economic tests you use to determine whether a business can repay its revenue share loan? How do you know you won’t default on the loan.
BENJI: Now that I’ve explained the basic loan terms, let’s discuss three basic economic points:
- What are the returns on investment for Revenue Share Loans?
- How do businesses know what terms they can afford to pay so that they don’t default?
- How do you decide whether selling equity or Revenue Share Loans is in the owners’ interests?
JIM: I’ll jump into investment returns first. There is a correlation between the payout multiple investors demand and the maturity date the business wants. For example, a Rev Share loan with a three-year maturity might be marketable to investors at a 1.5x multiple. For a five year maturity, investors might want a 1.75x multiple.
BENJI: Is there an upside for the investor? Or is it always the same rate of return?
JIM: The total amount the investor receives is fixed, but the shorter the length of time the company takes to fulfill its obligation — the quicker the payout and the higher the rate of return (ROI). If a company can convince investors that it can repay the loan quickly, it can attract investors with a lower payback multiple. If a loan has a five year maturity date and the company repays the loan in three years, investors can achieve double digit annual compounded interest rates. So, investors can “hit the jackpot,” if revenue increases faster than the company projects.
BENJI: Since the total amount investors receive is always the same, explain this jackpot concept.
JIM: The investor wins because the investor can reinvest any money the investor receives earlier than expected. Any profit from that reinvestment is a windfall for the investor.
BENJI: So, what are the best types of businesses to sell Rev Share loans?
JIM: The big three industries are: food, booze and software.
BENJI: I see the connection with food and booze, but what does software have in common with food and booze?
JIM: Restaurants, breweries and software all fit the model of starting to generate revenue after a relatively small investment. They also tend to have repeat customers. Software has the added advantage of having both relatively high margins and high annual revenue growth rates.
BENJI: That tells us about industries generally, but are there specific economic characteristics that tell us a particular business is a good Rev Share loan candidate?
JIM: The business attributes we look for when we recommend Rev Share deals are:
- Either a track record of having revenue or certain near term prospects for generating revenue so that investors will start getting money back within a few months.
- Companies that are or soon will become profitable. You can’t repay debt from revenue that you have to spend to pay your operating expenses. Revenue growth without profit growth can cause borrowers to default, because their monthly repayments increase at the same time their other expenses are increasing.
- High margins hold the potential for profitability, but that’s only true if management controls expenses. So, the best Rev Share candidates are business where expenses don’t grow as fast as revenue.
- Projections for high annual revenue growth rates enable companies to repay their loans from the faster growth they generate from the loan proceeds.
- The business can make a good case that every dollar invested in marketing or expanding production has historically resulted in multiple dollars of additional revenue.
JIM: We use the traditional the Debt Service Coverage Ratio that banks use to help businesses decide whether they can repay a Rev Share loan. Banks usually want a 1.25 or 1.3 to 1 ratio of adjusted net operating profit to total debt service obligations. A 1:1 ratio is theoretically sufficient to repay, but banks want a cushion to avoid defaults. Rev Share borrowers must decide how much of a safety net they want to build into their offering terms.
BENJI: Are there any other differences from how banks make loan decisions?
JIM: Banks also tend to be conservative about projected revenue and profit growth rates, which affect the Debt Service Coverage Ratio calculation after the first year of the loan. Business owners have to decide whether they really believe their own growth rate projections. If they believe their own projections, they can move forward based on projections a bank would heavily discount.
BENJI: How can businesses easily run the numbers to see whether they make the cut?
JIM: We have financial modeling tools that use the clients’ own data about current revenue and profits and projected growth rates to help clients quickly analyze multiple offering terms and repayment scenarios.
BENJI: What financial information do our tools give businesses?
JIM: Our tools calculate projected interest rates, projected repayment instalments and Debt Service Coverage Ratios based on the amounts they want to borrow, proposed maturity dates and the payback multiples they are considering offering investors.
BENJI: How long does that process take?
JIM: We collect relevant information from businesses using short questionnaires. A business can usually provide the information we need in less than ten minutes, if it already has historical financial information and projections
BENJI: So, then do we guaranty a successful payback? I don’t like the sound of that.
JIM: Of course not. Our financial modeling tools just show how the loan terms will work using the loan terms the business wants to test and the data and projections that businesses provide. Many factors affect whether the loan will actually be repaid. Projections are often wrong. If they are, the business may not be able to repay the loan.
BENJI: So, it all depends on the business’ own projections.
JIM. Right. Businesses decide what their projections should be. We just help businesses understand how the loan terms work in light of the data and projections they provide. Later in the offering process, we ask businesses questions about their projections that help them make disclosures to investors. Sometimes businesses change their projections because of our questions. Ultimately, however, businesses are responsible for their own data and projections. We don’t make that decision for them.
BENJI: So, what happens if business owners don’t know how to do projections? Are they out of luck doing an offering?
JIM: No. If the owners need help, we can recommend other experts to help them. It’s just not what we do.
BENJI: A lot of business owners are trying to decide whether to sell stock or other equity securities. Selling equity dilutes their stock ownership, but they need capital to grow so that they can eventually sell the business for a high price. Can you tell us whether Revenue Share Loans will provide a higher resale price for owners than selling equity?
JIM: Selling equity usually promotes faster revenue growth than borrowing does, because if you sell equity you are not repaying debt installments each month like you have to do with a Revenue Share Loan. That means the business can reinvest more money in growth every month.
BENJI: Is the slower monthly revenue growth significant?
JIM: Not in any single month, but it adds up over the 36 to 60 months of a loan.
BENJI: So, that means Revenue Share Loans will probably reduce the total resale price of a business compared to the resale price a buyer would pay if the business had sold equity securities.
JIM: But that’s not the whole story, is it?
BENJI: Of course not. When you sell equity, you’re selling the investors part of the resale proceeds. The original owners won’t receive all the resale proceeds. How do owners know what the best deal is after you take dilution into account?
JIM: Whether equity or Rev Share is a better dilution deal for the founders and earlier investors depends on a combination of the rate of return on investment the new equity investors would want and the multiple of revenue a buyer would pay at exit when the company is sold.
BENJI: Let’s deal with the multiple of revenue when the business is sold. There are pretty common industry standards to predict that. But things like growth rates, margins, net profits and balance sheet items like assets and liabilities can affect the actual multiple.
JIM: Right. The price a business will sell for is partially industry related, but company specific factors also play a role.
BENJI: Now, let’s deal with the investor expectation factor. Explain how that varies.
JIM: Investor return expectations affect the percentage of equity investors receive. Typically, venture investors want a 10x return on investment. Sophisticated angel investors are often willing to accept a 5x return on their investment. In either case, that means you give up a big percentage of ownership that usually results in the investors getting more of the sale proceeds when the company is sold.
BENJI: 10x sounds pricy. I could buy my own island if all my investments paid 10x.
JIM: Of course, most investments don’t return 10x and Crowdfunding equity investors often expect less. So, a business might find equity investors in the Crowd who only require a 3x return in investment. If that happens, you might be better off taking the dilution by selling equity to boost revenue growth, but only if you can sell the company for a very high multiple of revenue.
BENJI: So Jim, what’s the bottom line?
JIM: Whether equity or Rev Share is a better deal for the founders and earlier investors depends on a combination of the rate of return on investment the new equity investors would want and the the multiple of revenue a buyer would pay at exit when the company is sold.
BENJI: So, you’re saying “It depends.” That sounds like the type of evasive answer people don’t like about lawyers. Give the folks a break. Be more specific.
JIM: OK. Here it goes. In most scenarios, our numbers crunching indicates that selling Revenue Share loans produces a higher net sale price at exit to existing owners than selling equity does. In short: Rev Share loans protect not only against percentage dilution but protect against value dilution. I hope I don’t get disbarred for giving a clear answer.
BENJI: That wasn’t really so hard. Was it?
JIM: I just hope I don’t get disbarred for giving a clear answer without any hedges.
BENJI: You’re right. That’s totally not very lawyerly behavior, but we’re not your average lawyers.
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
Why Investors and Businesses May Not Love Revenue Share Loans
The content contained on this article does not provide, and should not be relied upon as, legal advice. It does not convey an offer to represent you or an attorney-client relationship. All uses of the content contained in this article, other than for personal use, are prohibited.