In the wake of escalating climate change concerns and the rising demand for local and organically grown food, smaller farm and food ventures are looking to grow. Unfortunately for farmers and other food entrepreneurs, growth requires capital, and the typical forms of debt and equity financing may not be a good match for their businesses. Thankfully, investors and entrepreneurs are turning to more innovative forms of financing. One example is revenue- or royalty-based financing (“RBF”) — a hybrid of debt and equity financing that can offer the flexibility farm and food ventures need to fuel their businesses.
To understand the benefits of RBF, it’s worth taking a quick look at the two common forms of financing.
Debt financing involves a loan that the borrower must repay with interest according to a fixed schedule. Lenders usually retain a security interest in the borrower’s assets so that if the borrower defaults, lenders have a way of getting some of their money back by seizing and liquidating the assets. This form of financing can be unattractive for farm and food start-ups because they typically do not have the physical assets to serve as collateral for the loan. In addition, it can be challenging to meet fixed loan payments when cash flow is sporadic and often dependent on conditions beyond the entrepreneur’s control, such as weather or pests.
Equity financing can be less restrictive in some ways, but more restrictive in others. Equity financing involves the contribution of capital by investors in exchange for an ownership stake in the business. Although companies that receive equity investments are not usually tied to a fixed repayment schedule or required to pledge assets, entrepreneurs usually give up control rights to equity investors in the form of board seats, voting rights or, in some circumstances, the right to seize control and sell the business. This form of financing could be particularly problematic for a new farm, food hub or other similar venture that may not be on the path to the quick, exponential growth that equity investors often expect.
RBF is an alternative financing structure that helps balance the entrepreneur’s interest in retaining control of the business and the investor’s interest in getting compensated for risk. With RBF, investors make a loan to the company with a repayment schedule that is not fixed but is instead tied to the borrower’s revenue. The loan is fully repaid when cumulative payments reach a total dollar amount, often called the “repayment cap,” which is equal to the amount of capital contributed plus some additional amount to compensate the investor for the risk. In some instances, there may still be an outside date (the “maturity date”) by which the loan must be repaid but mission-oriented investors providing “patient capital” may agree to a maturity date that is more manageable than that of a conventional term loan or negotiate for no set time at all. Investors often get a security interest in the borrower’s assets. However, unlike traditional loans, that security interest might consist primarily of intangible assets (e.g., accounts receivable) instead of physical assets, and there may be no requirement for a personal guaranty.
In comparison to a traditional bank loan, the effective interest rate with an RBF loan can be higher, typically between 18 and 30 percent. However, prior to the maturity date, the borrower would only have to pay that amount if and when the business performs well. In comparison with traditional equity financing, an RBF financing can allow entrepreneurs to retain full ownership of their business, which is an appealing feature for food-based entrepreneurs who are looking to grow their business over the long term.
This type of financing can also create a symbiotic relationship between the investor and the business owner. RBF investors have a strong incentive to help the company grow, be it through business contacts, helpful advice, or additional financing, because the more revenue a company generates, the more quickly the investor gets paid (and swifter payment boosts the investor’s “internal rate of return”). Furthermore, RBF financing provides investors with built-in liquidity that they wouldn’t get with equity investments, reducing the risk of a conflict between business founders and investors regarding exit strategy.
To further suit the individual needs of a business and its investors, there are many ways to structure revenue-based loans. They can vary in their amount, duration, royalty rate (i.e., percentage of revenue that goes to paying down the loan), repayment cap, and other terms governing the operation of the business. The parties can also vary the financial metric to which loan payments are tied, using gross revenue, net revenue, EBITDA or some other measure customized to the company’s business plan and designed to further align company and investor interests.
With this flexibility, however, comes a few potential traps for the unwary. Because RBF financing features elements of debt and equity, the IRS could treat a particular transaction as an equity transaction for tax purposes when the parties intended it to be a debt transaction (or vice versa). This kind of re-characterization, which is fact-specific and dependent on the terms and structure of the financing, could have adverse tax implications for the parties, including the failure of the borrower to obtain tax deductions for interest payments if the transaction is viewed as an equity investment. Another potential trap involves state usury laws, which cap interest rates in an effort to prevent loan sharking. Massachusetts, for example, has a 20% cap although it is possible to obtain relief from the cap by providing the Attorney General with notice of the transaction. For these reasons, it is best to consult a lawyer and tax professional when structuring an RBF financing.
For additional information, listed below are some of the investors in the Northeast using RBF (as well as other financing mechanisms) to support sustainable food and agricultural enterprises. The descriptions below are drawn from their respective websites.
- Flexible Capital Fund L3C (Flex Fund) provides creative financing in the form of near equity capital (subordinated debt and royalty financing) to Vermont’s growth-stage companies in sustainable agriculture and food systems, forest products, and clean technology sectors.
- Fresh Source Capital is a Cambridge, MA based investment firm focused on sustainable food and agriculture. The firm's mission is to invest in companies that are rebuilding local, regional food systems. It provides alternative financing options, including debt, royalty, and selected equity, to growth-stage companies with a focus on the Northeast region.
- Fair Food Fund provides financing and business assistance to good food enterprises that connect small and mid-size farms with consumers hungry for local, sustainably grown food. The Fund works with enterprises that support the long-term financial viability of small and mid-size farms in the Northeast.
For further information about these matters, please contact Jonathan Klavens at firstname.lastname@example.org or 617-502-6281.
We wish to acknowledge the valuable contributions of Mark DeFeo and April Herleikson in the research for and drafting of this article.
This document, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Klavens Law Group, P.C. or its attorneys. Please seek the services of a competent professional if you need legal or other professional assistance.
© 2016 Klavens Law Group, P.C. All rights reserved.