Perhaps the most crucial challenges in operating a small business are maintaining a working capital and keeping the business liquid. The two challenges are interconnected. Working capital refers to the assets you have remaining after deducting your liabilities. To maintain liquidity, you have to ensure that your current assets include cash and other items of value that can be easily converted to cash. 

In some cases, business owners need revenue-based financing, or other types of funding solutions such as small business loans. In this guide we will explain the key differentiators between revenue based financing options, and small business loans.

How small business loans are different from revenue-based financing

Liquidity is essential to your business’s ability to pay liabilities and continue operations. The greater your company’s liquidity, the greater is its capacity for growth and its ability to survive unforeseen reversals. Strengthening your liquidity will require increasing your working capital. 

To boost your working capital, you can improve your payments collection process, streamline operations to increase profitability, or obtain business funding. 

The third option can be used strategically, not just to improve your cash flow at a critical time but to establish your creditworthiness even before that time comes. Applying for financing while you don’t need it yet, and then building a solid payment history through it, will facilitate obtaining more funds from your lender in the future, when your need may be more urgent.

You may look into two types of funding sources: small-business loans and revenue-based financing.

There are various types of small-business loans, among them: 

Small Business Administration (SBA) loan – low-interest, long-term loans guaranteed by the U.S. government’s SBA loan program and typically accessed through banks. The requirements can be stringent: high credit rating, adequate cash flow, generally stable finances, and the capacity to continue operations while awaiting funding. 

Term loan – cash in a lump sum, provided in exchange for a set repayment period with interest, sometimes requiring a down payment. Term loans are suitable for small businesses with stable finances.

Line of credit – access to a specified amount of cash which you repay, usually with interest, when you begin to access the funds. 

Traditional banks offer the types of loans listed here, but their requirements can sometimes be too stringent for small businesses or start-ups. Banks usually require business loan applicants to have been in operation for several years and to have a high credit rating, strong cash flow, and consistently well-managed finances. In addition, some banks may require collateral.

Banks also prefer loan applicants who carry low risk and high profitability. These are more likely to be larger, more stable businesses or at least businesses that demonstrate strong growth potential, rather than small businesses that have yet to establish themselves.

There are alternative funding solutions for the underserved small business sector. Online lenders, also called alternative lenders, specialize in providing one or more of the financing services listed above. Their target clients are small businesses that may not qualify for loans from traditional lenders like banks, credit unions, or government loan programs. 

Another type of funding available to you from some alternative lenders is revenue-based financing, in which you repay an agreed-upon amount with a percentage of the revenue generated by your business. 

The repayment period is flexible – it lasts for as long or as short a time as it takes to reach the target repayment amount. The catch is that the target amount can be 1.5 to 2.5 times the loaned amount. 

The financier can also set qualifying requirements that a relatively young business may find difficult to meet. For instance, you would need to show hard data proving that your company had solid and steady earnings over the past three months or more. 

The financier may also require data proving that your business stands to increase its monthly revenue in the future. 

Invoice financing or factoring – exchanging amounts due from customers for business funding. In invoice financing, customers’ invoices are used as collateral to obtain the funds. In invoice factoring, the invoices are sold to a factoring company that takes over the collection of payables. In both cases, the lender collects a percentage of the invoice total as a lending fee. 

Equipment-based financing – a loan obtained to purchase equipment, using the same equipment as collateral. This type of financing may also cover all or a portion of related expenses such as equipment delivery, installation, assembly, etc. The loan is repaid over a specified period with interest. 

Is revenue-based financing a better version of merchant cash advance?

An older version of revenue-based financing is the merchant cash advance, a financing extended by banks or alternative lenders to businesses with credit ratings below those required for more traditional loans. A merchant cash advance is a suitable option for companies with sharp dips and peaks in their monthly revenue and cash flow. 

An alternative lender will assess your creditworthiness for a merchant cash advance through a variety of factors including time in business, monthly revenues, and credit rating. Credit rating is not the only variable considered. Instead, the lender will look at how much monthly revenue your company has recently generated from credit and debit card transactions and through online payment services. The funding amount that your company may receive is based on this revenue record.

A noteworthy difference between revenue-based financing and merchant cash advance is in the structuring of payments

The target repayment amount in revenue-based funding is computed using the formula Loan Amount x Payment Cap. The payment cap usually ranges from 1.35 to 3.0. 

Payments based on the calculated amount will be deducted from your monthly earnings. Depending on the terms of this loan, the deductions can range from 2% to 8% of monthly revenue.

The target repayment amount for a merchant cash advance is computed with the formula Loan Amount x Factor Rate. The factor rate typically ranges from 1.1 to 1.5. 

Payments based on the calculated amount will be deducted from your daily, weekly, or monthly credit and debit card proceeds at an average retrieval rate of 15% to 25%. This rate is negotiable as merchant cash advance providers want to be sure you have enough revenue after payments to continue operating.

Which type of funding costs more to repay? That would depend on the payment cap or factor rate applied to your financing amount.

Finding the right alternative funding solution for your business.

In the end, the right alternative funding solution for your business will depend on where it stands in relation to the funding source’s requirements. 

Do a rigorous assessment of your company’s finances and performance over time. Determine how much working capital you have and how much you still need to sustain operations and improve liquidity. Check out the different solutions offered by alternative lenders. Consult with these lending companies’ representatives to better understand whether their solutions fit your needs.

Keeping in mind that whatever solution you decide on will essentially be a funding that you must repay, evaluate your capacity to repay that financing within the terms offered by the lending company. When you have all the information you need to make a wise choice, select the lender and the financing solution that is best for you.