Revenue-Based Financing Underwriting: Balancing Growth and Risk

September 16, 2024

Revenue-based financing (RBF) has emerged as a compelling alternative for businesses seeking growth capital without the impediments of equity dilution or strict debt terms. As the RBF landscape expands, so does the need for robust underwriting practices. In this post, we’ll explore the strategies and insights that drive successful RBF underwriting teams.

RBF offers undeniable benefits: flexible remittance tied to revenue, quick access to capital, and no equity surrender or personal guarantee. Yet, this rapid growth and flexible benefits underscores the importance of prudent underwriting. As risk professionals, we’re tasked with assessing customer viability, mitigating potential losses, and aligning RBF terms with risk profiles of each client. Underwriting teams should have deep interest in client success and provide capital that benefits their business and supports growth.

A Holistic Approach to RBF Underwriting

While RBF’s focus on revenue is central, underwriting goes beyond simple revenue calculations. A holistic risk review includes:

Revenue Quality

• Stability: How predictable and consistent is the revenue stream? Are there seasonal fluctuations or over-reliance on a few large customers?
• Growth: Is the company’s revenue growing, and what is the trajectory? Growth indicates potential, but rapid, unsustainable growth might be a red flag.
• Margins: Margins offer insight into a company’s pricing power and cost management. Higher margins often reflect greater resilience to downturns.

Business Model

• Industry: Some industries are inherently more volatile or risk-prone. Evaluating the company’s position within its industry is crucial.
• Customer Base: A diversified customer base is generally safer than relying on a few key clients.
• Competitive Landscape: How strong is the company’s position relative to its competitors? Are there barriers to entry that protect their market share?

Financial Health

• Cash Flow: Positive cash flow is crucial, particularly for early-stage companies. It demonstrates the ability to meet ongoing expenses and remit.
• Burn Rate: How quickly is the company spending its cash? A high burn rate may signal the need for additional funding, potentially affecting future remittances. Average daily and ending balances offer insight into cash flow stability.

Key Underwriting Strategies

A thorough risk assessment is the cornerstone of RBF underwriting. Key strategies include:

• Scenario Analysis: Don’t just rely on current performance. Model different revenue scenarios and sensitivities (e.g., optimistic, pessimistic, most likely) to understand the full range of outcomes and the impact on remittance ability.
• Cohort Analysis: Study the performance of similar customers in your portfolio. Are there patterns or trends that can inform your risk assessment of a new applicant?
• Industry Benchmarks: Compare the company’s performance metrics (e.g., revenue growth, margins, customer churn) to industry averages. This helps contextualize their performance and identify strengths or risks.

Qualitative Factors

In addition to quantitative analysis, qualitative factors play a critical role:

• Management Team: The experience and track record of the management team can significantly influence a company’s success.
• Market Opportunity: How large and attractive is the market the company is targeting? A bigger market often means greater potential for growth.
• Regulatory Environment: Are there regulatory changes on the horizon that could impact the company’s business?
• Reputation: Consider community support and online reviews. Are online reviews negative? Do negative news searches to find areas of concern that could put remittance at risk.

Aligning Pricing with Risk

RBF pricing should align to the customer’s risk profile.

• Revenue Share Percentage: Higher-risk customers may require a higher revenue share percentage to compensate for the increased risk of default.
• Term Length: Longer terms can reduce the monthly payment burden for customers but they may also increase the total cost of financing over time.

Final Thought

Robust underwriting is essential for both funders and customers. By carefully evaluating risks, tailoring terms to the customer’s risk profile, and staying informed about industry trends, RBF can continue to be a viable and attractive financing solution. For funders, disciplined underwriting practices ensure a balanced risk-return profile, making RBF a sustainable option for growth-focused businesses.