- Revenue-based financing is a great option for founders who want to retain the most control over their business' futures as possible.
- Niche venture capital firms can offer the expertise, connections and oftentimes customers that more general VC firms can't, especially for B2B companies.
- For a relatively red-tape-free approach in underserved areas, Opportunity Zone funding can apply to just about any industry.
Most entrepreneurs are familiar with traditional funding methods, such as bank loans, crowdfunding and big-name venture capital, but not every business is a good fit for such avenues. You may not have the credit rating nor cash flow to qualify for a small-business loan, for example, or maybe your concept isn’t yet proven enough for your banker. There’s the risk of VC firms ignoring your business, and if you can get their attention, they may not have the industry-specific connections nor experience you want in exchange for selling some of your company. Many crowdfunding investors, meanwhile, also want equity or some other reward — and that’s if you can get enough of them to drive substantial investment.
There are options beyond these more traditional funding methods, and they may very well be right for you. We consulted experts to explore three alternative funding routes for growing businesses.
Get an overview of alternative funding methods, which we’ll cover in detail below:
1. Revenue-Based Financing
Revenue-based financing, also known as revenue-based investing (RBI), started to really gain steam in the 1980s, and many entrepreneurs aren’t clear on how it works. We asked expert Cheryl Contee, to explain. Contee is an entrepreneur and chief innovation officer at The Impact Seat (TIS), an investment firm specializing in women-led and women-of-color-led, innovative startups. TIS is the lead investor of Founders First Capital Partners, where Contee leads revenue-based financing strategies for small businesses. Contee is also big on Twitter and an expert with wiseHer, an advice network for entrepreneurs to help accelerate their business and career growth.
Brainyard: What is revenue-based investing, in simple terms?
Cheryl Contee: RBI is all about providing capital to businesses. As the business owner, you sell an ongoing percentage, usually 1% to 3%, of future revenue to the investor — until you reach an agreed-upon multiple, typically three to five times the original amount invested.
Unlike other investment methods, with RBI, you’re not selling equity, a board seat or a piece of the company — just revenues. You retain quite a bit of control, and it isn’t debt. There’s not a fixed amount you have to pay no matter what happens with your business. If you make $1 million this month, then you pay 2.5% of that. If you make $100,000 next month, then you pay 2.5% of that, until you hit that multiple.
BY: What are the advantages and disadvantages of revenue-based financing over other funding methods?
CC: Unlike with traditional debt loans, you don’t have to be wildly profitable to get funding. Even private equity firms want to see a fast path to profitability. RBI isn’t necessarily geared toward that hockey-stick growth. Investors want to see just a steady path of increasing revenues, not a moonshot.
But RBI does take a portion of revenue you might want to use for other investments like staffing, expanding your tech stack or R&D. You lose access to that revenue, whereas in an equity deal, you retain it. One to three percent doesn’t sound like a great deal of money, but sometimes when you’re an entrepreneur, you’re right on that razor’s edge and it can make a difference.
BY: Which types of companies is revenue-based investing best for?
CC: RBI is best for services companies with recurring revenue streams. When you have those recurring revenues, again, you’re not necessarily on that hockey stick, but you’ve got steady revenue growth. Sometimes, investors are looking for only tech companies; we see a lot of RBI in the tech space. If you’re a SaaS company, there are lots of RBI funds looking for you.
You can find revenue-based financing through specialized RBF firms and some venture capital firms that offer deals in this structure. An online search will return a slew of revenue-based funds which you can research; here’s a starter list of major revenue-based investing VCs(opens in a new tab).
BY: What are the requirements for a company to qualify for RBI?
CC: Your EBITDA should look really good: at least 25%. Investors want to see customer diversity — at least five or more clients – so you’re not dependent on one or two clients for revenue. Remember that you don’t need profitability, unlike in debt financing, but investors do want to see those recurring revenues. B2B companies are attractive; those contract revenues are really appealing. RBI isn’t necessarily looking for startups but rather SMBs with steady, strong growth.
BY: When isn’t revenue-based financing a good option for a business?
CC: It doesn’t work if you don’t have strong monthly revenues, which is true of many startups that are still building a customer base. When you talk about equity funding, sometimes that’s a bigger investment over time. You’re in a different ballpark, in that hockey-stick model. If there’s a Series A or B in your future, or if you have a goal to IPO, then you’re better off in an equity model with a different group of advisers and investors.
BY: Are the KPIs different between RBI and equity funding?
CC: It’s pretty straightforward in RBI: MRR, ARR, recurring run rates, gross margins and EBITDA. On the equity front, they’re looking at the size of the idea, not just the health of the business.
BY: How does a company identify the right funding vehicles or organizations to target when looking for revenue-based investment?
CC: Look to the founders of the firms that specialize in RBI. Who are the people running it? What’s their background or reputation? You don’t want “sharks;” you want them to build the company with you. Understand their integrity. Who are they investing in, and what has their success rate been? The best investors don’t just provide money. They provide resources, connections, ideas, network and education. RBF firm Founders First, for example, has an accelerator with coaches and advisers to help startups achieve their goals.
BY: Can you give me a real-world example of how revenue-based financing works?
CC: Company A wants to expand. It needs $1 million in capital to execute on growth like hiring more sales staff, improving technology or getting more warehouse space. You’d approach an RBI firm. Work out a deal in which you give 2.5% or so of monthly revenues until you get to a 2x multiple. You’re paying it back over time. You don’t have to agree to valuation, which is a sticking point in equity financing where valuation makes a difference in the value of shares and value of investment. Some RBIs want to see milestones and might want to do follow-on investments as you continue to grow, just like on the equity side, or you might just part ways at the end of the deal.
For more, see the Corporate Finance Institute’s revenue-based financing(opens in a new tab) guide.
2. Niche Venture Capital Firms
Unlike traditional VC firms, which provide funding to a range of companies in various market segments that display high-growth potential, a niche or boutique VC firm has a clientele, portfolio and skill set that are specific to a particular industry, demographic or geographic area. They’re often smaller than “super-giant” VC firms. To understand the benefits of pursuing funding from a niche VC firm and what to expect from the process, we turned to expert Vida Asiegbu, a principal with Energy Impact Partners, a niche VC firm that specializes in energy companies and works specifically with utilities and industrial partners, to cover. Asiegbu is also an expert with wiseHer.
Brainyard: Can you remind us of the benefits of taking VC money, whether from a niche firm or not?
Vida Asiegbu: The VC industry is a great place for companies — specifically those that can touch a medium-large segment of the market — to find capital outside of banks to grow and scale. It’s a good way to receive investment capital that a bank or another financial institution wouldn’t provide. Why would a bank go for an entrepreneur who doesn’t have revenue or a quick path to revenue? The bank has a fiduciary responsibility to lend capital only to proven organizations. VC investors with capital and a risk appetite shoulder that responsibility — and the potential benefit — for companies without a proven path to revenue. There’s a market of people interested in deploying capital for the potential return on risk.
BY: What are the benefits of a niche VC firm over a broader, more general firm?
VA: The real benefit of a niche firm is sector experience and understanding of the market. When a company wants an investor to help it grow, it’s about more than capital. It’s about expertise, support and connections. My firm, for instance, is in the energy sector. We work with utilities, which are the primary customers of energy companies. The contracts we’ve been able to deliver for companies in our portfolio are so valuable: We can gross $400 million for them through interactions with the utilities in our investor base.
It’s important for entrepreneurs to demand that if a firm is going to get a share of the company, it needs to do a share of the work. An entrepreneur must align their business with compassionate and helpful investors, which is why niche investors are really important.
BY: Where can entrepreneurs find these niche firms?
VA: You can start with an internet search, but make sure you go beyond that. Twitter can be helpful for seeing what VC firms are talking about and advice they’re giving. Publications are helpful in seeing who is investing in what: For example, Fortune’s “Term Sheet” newsletter rounds up deals being announced. Listen to podcasts, and attend VC-related Clubhouse chats(opens in a new tab). Finding a niche VC firm isn’t as simple as just Googling; you have to do that research.
3. Opportunity Zone Funding
According to the 2017 Tax Cuts and Jobs Act, a Qualified Opportunity Zone (QOZ) is an “economically distressed community,” as the IRS puts it, in which traditional investment funds can receive tax benefits for investing in businesses that meet certain criteria. There are about 8,700 QOZs in the U.S. — so odds are there’s one near you. Here’s a nifty Opportunity Zones mapping tool(opens in a new tab).
To be designated a Qualified Opportunity Zone Business (QOZB), an organization must meet five criteria:
1. Seventy percent of its tangible assets, including new capital the company might’ve recently raised, have to be in a Qualified Opportunity Zone. Assets in existence before 2017 don’t count — the legislation wanted new investments — so Opportunity Zone funding won’t work for companies with significant historical assets. This isn’t much of an issue for young businesses; it’s harder for older companies to qualify because they’ve typically generated more than 30% of their assets prior to 2017.
2. Businesses have to pass what’s called a gross income test, which really concerns where employees work:
Half of all employee hours worked have to take place in the Qualified Opportunity Zone.
At least 50% of salaries and wages paid to employees must be for work performed in the Qualified Opportunity Zone. So if you have a storefront in a QOZ but the bulk of your payroll goes to workers at a production plant not in the QOZ, you don’t qualify.
At least 50% of the business’s gross income must depend on both the tangible property and the operational functions performed in the QOZ. If you’re an auto body shop that also sells used cars, for example, then at least 50% of your business property and 50% of your operational functions have to be within the QOZ. Say half of your tangible property is your shop, which is in a QOZ, but the other half, your car lot, isn’t. In that case, half of your gross income has to be generated by operations performed in your body shop.
3. When a QOZB raises money, it must have a plan to use it over a 31-month period, and then it can’t keep more than 5% of its assets in cash. The legislation doesn’t want you to just park cash.
4. The fourth test is around intangible assets — mainly intellectual property, though brand reputation and digital assets like social media capital also fall into this category. To be considered a QOZB, your business must use at least 40% of its intangible property in the “active conduct of the business.” This “use” has to make sense: If you have high-value IP for a marketing automation platform but your income comes from selling dog collars, then you won’t meet this requirement. The intangible assets must also support actual work done in the Opportunity Zone.
5. “Sin businesses” need not apply. According to the regulations, “sin businesses” are: sun tan parlors; horse tracks and casinos; golf courses; country clubs; massage parlors; hot tub facilities; and liquor stores, defined as stores with the principal purpose of selling alcoholic beverages for consumption off-premises.
Note that during the pandemic, the IRS relaxed some of the Qualified Opportunity Zone rules. Consult a tax professional for further guidance.
Many types of investment firms can deal in Opportunity Zone Funding, from venture capital firms to real estate investors, family offices and private equity firms. For investors, there are significant tax advantages to working with a Qualified Opportunity Fund (QOF):
Tax deferral: If the investor has existing assets with accumulated capital gains, they can place them in a QOF and defer those assets until either Dec. 31, 2026 (when all QOZ designations expire) or when they dispose of the asset, whichever comes first.
Tax reduction: If the QOF holds a qualifying investment for at least five years, the basis on the original investment increases by 10% on the fifth anniversary — meaning a 10% reduction in the tax the investor otherwise would’ve paid. Since the program ends on Dec. 31, 2026, the investment must be made by then in order to qualify for this benefit.
Tax exemption: If the QOF investment is held for at least 10 years, then the post-acquisition capital gain is exempt from taxes altogether. Investors have to sell the investment by Dec. 31, 2047.
If your business is looking for investors and may have difficulty qualifying for a bank loan or attracting VC money, Opportunity Zone Funds can be a good source of capital. The National Council of State Housing Agencies has an Opportunity Zone Fund Directory(opens in a new tab) searchable by geography and industry. There are 236 QOFs in the U.S. representing an anticipated $48.3 billion in investments, according to the Council.
We asked expert Jay Bockhaus to further explain Opportunity Zone Funding. Bockhaus is managing partner at The CORI Innovation Fund (CIF), which invests in growth businesses located in Opportunity Zones, where traditional venture capital doesn’t tend to operate. CIF seeks technology startups, specifically: Think propulsion technology in Durango, Colo. and AI-driven behavioral healthcare technology in Springfield, Vt. Bockhaus is also an expert with wiseHer.
Brainyard: Tell us more about the process of finding and applying for Opportunity Zone funding.
Jay Bockhaus: I’ve seen it work the best where there’s a local resource acting as a matchmaker. For example, there’s Opportunity Alabama, which is funded by a local utility. It works like an economic development organization, looking for both investors and deals. It’s nice to have a resource like that that acts like a clearing house vehicle. There’s Opportunity Appalachia, Opportunity Virginia and so forth.
You can do a Google search for Opportunity Zone Funds. There are a couple of resource libraries, like Novogradac’s Opportunity Funds List(opens in a new tab), that index them. It’s a relatively red-tape-free application process for the business owner. The fund is responsible for making sure criteria are met, and it submits all of the compliance information to the Treasury.
BY: What is the typical amount that eligible businesses receive?
JB: It varies quite a bit, from seed-stage companies all the way up to massive real estate projects. Because there aren’t many barriers to moving forward, you can make Opportunity Zone funding work with most any size of project. There aren’t any million-buck legal expenses to shoulder, either.
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The bottom line
There are other sources of funding for your growing business beyond loans, VC and crowdfunding. Do your research, and don’t be afraid to reach out and ask questions of the investment firms or funds you’re interested in. There’s a funding vehicle that’s right for you; you may just have to think outside the box.
Kris Blackmon is the chief channel officer of industry consultancy JS Group. A veteran of the indirect sales channel, Blackmon created one of the most robust research communities in the channel via the MSP 501 program, written extensive editorial coverage on the channel and programmed and led the industry’s largest channel events, Channel Partners Conference and Expo and Channel Partners Evolution.