By Lukas Wagner.
Until very recently, accounting and finance had been the epitome of a traditional field—full of manual inputs and little fundamental change since those clever Venetian merchants came up with double-entry bookkeeping some 700 years ago. But in the past few decades, there’s been a huge upsurge in technology which has changed the game for accountants and the companies they keep afloat (let’s be honest). As CFO of a growing fintech company, I’m excited to see how technology is revolutionizing accounting and finance too.
In a very similar way, technology is also changing the way companies can access capital to fund growth. Real-time data connections make it possible to make informed decisions and run your company more efficiently. Those same data connections power financing decisions for debt and equity providers and even make a completely new financing model possible —recurring revenue financing.
Let’s take a look at what recurring revenue financing is, how it works, and how it impacts the financials.
First, the old way
Traditionally, when companies needed financing for growth, they chose between either raising debt or equity. Equity fundraising is, of course, dilutive, which isn’t a good fit for everyone—or even possible, given venture capital has historically really only been available to a select few with grand plans in even more grand addressable markets.
Debt has certain accounting benefits but isn’t always easy or practical to obtain—it may come with restrictive covenants, lack of freedom to spend as the company deems fit, and tedious reporting requirements. (Who doesn’t love building endless waterfalls and changing the whole team’s financial reporting calendar because of a single counterparty?)
Lastly, both debt and equity financing have traditionally taken months to put in place. Of course, there are new companies popping up and taking advantage of new technology to make the application and approval process more automated and streamlined, but the underlying financing is still burdened by restrictive covenants and dilution respectively.
Even with new technology in place to deliver these debt and equity options, they still have the same traditional underlying structure and sit on the financial statements in the same way. Nothing here you didn’t learn in Accounting 101.
A new model for a new asset class
With the explosion of companies offering subscriptions and membership—whether SaaS, direct-to-consumer subscriptions, or services with a membership model—predictable recurring revenue is becoming much more common. The reliability of that revenue represents an implicit asset for companies who have a much clearer picture of the future financial benefits from those customers than they previously had.
A new asset class and revenue model warrants a new financing model as well because the old constraints of traditional financing are no longer needed in many cases. This is where recurring revenue financing comes in.
How recurring revenue financing impacts the financials
Unlike traditional financing that’s simply delivered by new technology, recurring revenue financing is a new financing model that’s made possible by technology. It uses live data to algorithmically analyze recurring revenue streams. Those revenue streams are then sold to investors, who see them as a steady source of fixed-income-like returns.
Recurring revenue financing is sometimes confused with revenue-based financing (RBF), but the structure has major differences. RBF is a loan that uses revenue to determine repayment speed. Recurring revenue financing, on the other hand, treats revenue streams as assets which are sold to investors at a discount. Investors aren’t buying the subscriptions, just the underlying cash flows themselves: With Pipe, for example, the company continues to collect the revenue with no impact or disruption to the customers.
As I already mentioned, the most significant difference on the financials is that recurring revenue financing isn’t dilutive like an equity raise. It’s a straight asset sale with no impact on ownership whatsoever. While it’s not a loan, it tends to show up on the financial statements much more like one, because it is, after all, still a liability. Investors are paying up front for the right to the future revenue those contracts generate, so as revenue comes in, the company is liable to pay it out to the investors.
One of the biggest benefits of recurring revenue financing over a loan is the lack of warrants and restrictive covenants. Lenders tend to put these in place to protect themselves and make the bank comfortable parting with their money. Because recurring revenue streams are so stable—and because technology allows us to analyze them carefully—there’s no need for those restrictions. In addition, the trading of a year’s worth of revenue is just much more suitable structurally for a nascent business than a 5-year term loan—of course banks feel like they need incremental protections because the financial product doesn’t fit the customer. Alternative financing is good news for companies that need flexibility and agility in how they operate in order to grow, and the lack of warrant coverage further protects existing shareholders’ equity.
Another major benefit is the speed with which recurring revenue financing transactions take place. At Pipe, we have some users who trade revenue streams multiple times a week, and the capital is instantly available. That speed makes it possible to take only the capital you need, knowing that you can get more at any time. Unlike equity or loan financing, which can take several months to access, it’s easy to trade what you need and keep re-trading as you go. This not only keeps you from overreaching and paying unneeded financing costs, but it also means you can usually keep all trades within a 12-month period, avoiding any impact on long-term liabilities and the ratios they affect.
Far from the robot uprising that would take away all of our jobs, technology has mostly taken away stress and monotony. Now that accounting and finance professionals are spending less time with their nose to the grindstone, they have margin for more strategic thinking to help grow their companies. Technology is making it possible to finance that growth in a way that’s flexible and agile, without some of the downsides of traditional financing.
Lukas Wagner is CFO of the business financing firm Pipe.