Recurring revenue financing 101
Recurring revenue businesses charge a periodic fee for access to their services, often on a monthly or annual basis—think Spotify, Salesforce, LMNT, or the New York Times.
These business models have grown in popularity in recent years and come with a few benefits. Once a customer has signed up, all a company needs to focus on is making sure they don't churn. The longer the customer is subscribed for, the more time a company has to understand them. The more time a company has to understand their customer, the more predictable their contract is.
And yet, the benefits of recurring-revenue business models haven’t translated into capital. Even when companies have large numbers of predictable subscriptions, they’re often stuck waiting for their monthly or annual payouts.
Recurring-revenue financing attempts to solve this problem—what happens when you lend a company the money its customers would pay in the future? In this article, we’ll outline how it works, who it’s for, and when to decide to take it.
- Recurring-revenue financing can get you access to your customer’s future payments in exchange for a discount on your subscriptions.
- It’s debt, so you don’t have to give up equity—but you do have to pay back your lenders.
- Calculate the ROI of recurring-revenue financing carefully. Will it help you grow fast enough to pay back your lenders and invest in your business?
What is recurring-revenue financing?
Recurring-revenue financing gets you access to your customer’s future payments in exchange for a discount on your subscriptions.
Let’s say your company sells an app to track how much water people drink. You charge $5 a month and have high-quality subscriptions—you’ve kept churn (or the rate at which customers are canceling) low, only losing about 20% of your customers since your launch a year ago. In total, you have 1,200 customers.
A lender on a recurring-revenue financing platform like Capchase might offer you $44 upfront in exchange for one year of a customer’s contract ($48).
You can instantly put this money towards improving your product, expanding your team, or marketing to new customers. On the other end, your monthly payments go straight to your lender.
Each recurring-revenue lender has a unique underwriting model to determine how much money you’ll receive upfront and the total amount of credit you’ll have access to. Lenders usually take a few things into account:
- Your existing revenue traction: As of January 2021, typical eligibility for recurring-revenue financing is 4 to 5 months of subscription history, and over $10K in monthly recurring revenue (MRR) or over $120K in annual recurring revenue (ARR).
- Your revenue growth: How fast is your revenue growing? You can measure this month-over-month or year-over-year.
- Your subscription quality: How long have they been with you? Are they buying other things from your company, like merchandise?
- Your retention: What’s your churn (or the rate at which customers are leaving)? How long does the average customer continue paying for your product? The longer your retention, the more predictable your subscriptions are.
What happens if I can’t pay?
If your customer churns, you can swap in a new subscription to pay your lender for the remainder of the financing period. If you don’t have any other subscriptions, you’ll have to pay out-of-pocket.
What terms should I know?
The concept of advancing companies for future payments has been around for a while. One option is revenue-based financing, which operates on a similar thesis to recurring-revenue financing—companies should be able to have access to predictable future payments before they hit their bank accounts. However, revenue-based financing has its criticisms. Most methods take a strict percentage of future payments, meaning that your lenders get more money as your company grows.
On the other hand, recurring-revenue financing is considered a better fit for subscription businesses. They tend to work on flat rates and operate at the cadence of subscription businesses. They grow with you, but only by increasing your trading limit.
For example, Capchase takes a sum of money for your annual subscriptions and gives you the rest. Or Pipe connects you to lenders on a marketplace that treats subscriptions as tradable assets (Pipe makes money by taking a small cut from both sides for using the platform). There’s little standardization across these platforms, but there are a few common terms you’ll come across.
- Amount: The amount refers to the total capital that you can draw up to your credit limit.
- Credit limit: The credit limit is a fixed percent of forward-looking annual recurring revenue. Depending on the platform, this number can change based on the health of your subscriptions.
- Discount rate: The discount is a fixed percentage applied on your total contract’s value that is taken by the platform. It’s generally calculated when a draw request is submitted.
- Draw: A draw refers to when you withdraw money.
- Cadence of draws: Cadence is the number of times you can draw money up to your credit cap.
- Minimum draw: The minimum draw is the lowest amount that you can draw at any point.
- Duration: The duration is the amount of time you can draw money for.
Why would I raise recurring-revenue financing?
You have a subscription business with a few steady contracts. As mentioned above, as of 2021, typical eligibility for recurring-revenue financing is 4-5 months of subscription history, and over $10K in monthly recurring revenue (MRR) or over $120K in annual recurring revenue (ARR).
You want access to capital quickly and need cash flow. Platforms like Capchase and Pipe let you raise recurring-revenue financing within days. Additional cash flow can be useful for improving your product or accelerating your company’s growth—whether that’s to hit your own milestones or to hit external milestones that make you more appealing to VCs.
You can get it from anywhere. Recurring-revenue financing is geography agnostic—all lenders care about is the quality of your subscriptions.
It’s a good fit for subscription businesses. Many subscription businesses—particularly software-driven ones—find it hard to raise capital from big banks. Banks are accustomed to lending to mature, asset-heavy businesses. Recurring-revenue lenders understand subscription businesses well and can offer better terms than a bank loan.
You want to avoid dilution from VC funding and reduce the cost of capital. Unlike venture capital, which dilutes equity, revenue-based financing doesn’t take any equity.
You want to avoid discounting your customers. Subscription companies often discount heavily to get customers to sign up for annual subscriptions so they can get cash upfront. For example, a video conferencing software that charges $14.99/month might discount its yearly rate to $130/year. Recurring-revenue financing can be a more affordable alternative.
You want to avoid typical debt restrictions. Debt comes with complicated terms like warrants and covenants which can place unnecessary burdens on your business. Recurring-revenue financing does not.
You want to avoid giving up board seats. In addition to ownership in your company, venture capitalists often demand oversight of your company by sitting on your board. Revenue-based financing imposes no such constraints.
You have plans to raise other types of capital—but you aren’t ready just yet. Recurring-revenue financing can be tapped when you want it and works alongside other forms of capital, like VC.
What should I be careful about?
Like all capital, it’s important to remember the dangers of recurring-revenue financing.
If you have high churn or a small number of subscriptions, you won’t be able to raise much money from recurring revenue financing. Venture capital might be a better option if your business has a vision but not much revenue yet.
Calculate the ROI carefully. Map out several scenarios that take the implications of recurring-revenue financing into account. Consider the ROI—is the price of the financing worth the payoff?
For example: is using cash from recurring revenue lenders to hire a new engineer today worth having to repay lenders over several months? Would an investment in growth marketing generate enough cash to repay your lenders and keep your business moving?
Recurring-revenue financing is like debt: it’s a promise to pay lenders back at a fixed rate. If you don’t know how you would spend the cash or can’t estimate the ROI of raising funds, it might not be right option for you.
Want to learn about other types of financing?
Capital is the lifeblood of startups. However, there’s not much education on when, how, and why to use it. Read about other types of financing in our guide, plan for your startup’s future, and get to know what type of capital might work best for you.