When it comes to funding, there are two dominant options: equity and debt. Similar to equity approach, debt investment carries some degree of risk but represents a loan, typically with an interest. In general sense, debt is a purchase of bonds or debt obligations. This is a heedful approach to receive fixed return since the bonds are backed by issuing company: if the bond goes into default the organization will receive a poor credit or bond rating and the investors can obtain a profit by seizing the company’s assets. So the level of risk is associated with the underlying debt investment’s rating – those that are rated lower are more likely to default.
Keeping that in mind, investors today are looking for alternative investment approaches to diversify their portfolios – and debt provides many instruments to do so:
Consumer Loans – firms giving an opportunity to invest in the loans they grant. The leading firm in this category is Lending Club, with an online platform enabling investment in their debt – over $13 billion loans issued.
Micro Loans – small loans that can start as low as $100 to small business owners or entrepreneurs typically in developing countries. Leading company here is Kiva with over $800 million in no-interest loans.
Factoring is buying the debt – a factor may pay the seller 60% to 80% of the amount owed and then try to collect the entire amount receivable from the debtor. This is investing in debt that’s owed to the secondary creditor.
Another approach that is gaining popularity and interest is Royalty. Royalty-based financing is a hybrid small business loan that combines assets from venture-capital funding and bank loans. It became common even among the venture firms like Royalty Capital Management, Rockwater Capital and BDC Capital. Royalties are a unique form of investment that provides a stable, fairly low-risk alternative for investors. Instead of owning a share of the company’s stock that fluctuates daily, investors are guaranteed a monthly/quarterly/annual payment that is based on the company’s revenue. In other words, investors lend money for a guaranteed percentage of revenues for whatever the business is selling. This debt repayment method has a time limit or a return cap – once reached, the debt is repaid. And usually, the revenue shares range from 2% to 6%.
Royalty is a great way to fund a business, especially if entrepreneurs are allergic to sharing company ownership. There is no need to agree on a valuation of the business, there’s no personal liability, and there are no worries during a down month for sales, because payments are tied to a percentage of revenue. There are advantages for investors as well: the returns come in sooner since there is no waiting for an exit. The downside is that this funding model applies to those who have stable revenue – business needs profitability to sustain the revenue payout so the profit margins should range from 30% to 40%. To sum up, it is a loan that aligns entrepreneurs’ and investors’ success.
StartWise is a crowdfunding platform enables individuals to invest in private companies in return for a fixed percent of company’s quarterly revenue. The company pays its investors until they have received a multiple return on their investment.