The relevance of revenue-based finance in times of Digitalization

Christian Czernich talks to FYI and explains why revenue-based finance is an essential tool in driving Europe’s digitalization.

For Your Business published an interview with Round2 Capital CEO Christian Czernich. The original has been published in German, you can read it here.

This is a translated interview

The spectrum of financing for young companies has widened steadily in recent years. In addition to VC, there are now a whole range of providers of venture debt (risk-based loan financing). So-called revenue-based financing is still little known. There is an innovative investment fund in Austria that invests in seeded startups looking for growth capital. For an investment, the fund does not take company shares, instead the company gives investors a share of the revenues.

  1. Can you please explain how revenue-based finance works exactly? What kind of returns can be expected? How long are you typically invested?

Most of the business models of digital companies are built on a high percentage of recurring revenues. Revenue-based finance uses these recurring revenues to provide growth financing to young companies without diluting shares and without lengthy negotiations about company valuation. Technically, it works by providing the company with a subordinated loan whose repayment is linked to revenue. The revenue share typically ranges from 2-6%, depending on the amount financed and the company’s revenue, and consists of both a repayment and an interest component called royalty. The revenue share is paid until a certain multiple of the financing amount, which is between 1.35x – 2.15x, has been paid. When the multiple is reached after 4- 6 years, the financing automatically expires. If the company is sold before the multiple has been reached organically, the outstanding amount plus a variable exit fee is paid upon exit.

The revenue-based finance instrument can in certain cases replace an equity investment but can also be combined very well with an equity investment. Round2 selectively offers young companies a combination with equity. Revenue-based finance is a very simple and completely transparent financing instrument that allows especially digital companies to monetize recurring revenues without giving away shares. By linking it to revenue, repayment automatically adjusts to the company’s cash flow and thus cannot put companies in a bind. This flexibility is a significant difference to conventional venture debt financing. The return on the financings depends in particular on the sales growth of the companies and is on average 12-15% in the portfolio. The return of the fund can be significantly increased again by the exit fees and selective equity investment.

2. Why is now a good time for revenue-based finance? How is revenue-based finance received in the market? How did you get started and who are your investors?

When we started developing revenue-based finance for the European market in 2016, digitization was still in its infancy and the financing market for young digital companies was not very developed. At that time, we saw a big gap in the financing market, as the share of digital companies would steadily increase, but at the same time banks did not have the necessary structures or the right financing tools to finance digital companies based on intangible assets. That was the first gap in the market. Venture capital was then, and for the most part still is, the only external form of financing that company founders can access. When I was a student at Stanford, I had studied venture capital in detail very early on. Even then, I came to the conclusion that venture capital is a very powerful financing instrument, but it is far from being suitable for all company founders and business models. Due to a lack of alternatives, venture capital is often used with companies or in situations where it doesn’t really fit. That was the second gap in the market. We saw Revenue-based Fianance as a very good tool to fill these market gaps between banks and venture capital.

Our assessment of the market and the potential of revenue-based finance has since proven to be correct. Not least due to the Corona crisis, digitization has accelerated significantly and digital companies are part of the mainstream. The market potential is correspondingly large and growing strongly. Initially, company founders were understandably still somewhat reluctant. In the meantime, this form of financing is also much better known in Europe and our track record shows that it simply works very well. We are in the midst of an upheaval in the financing market and revenue-based finance will play an increasingly important role as an alternative form of financing. Accordingly, Round2 is on a strong expansion course. Today, Round2 manages EUR 30 million. Mainly from entrepreneurs and family offices from Sweden, Germany, and Austria. As a next step, we will now open the fund to institutional investors and significantly increase the capital under management.

3. You have already made 18 investments since 2017. Which companies does Round2 Capital focus on? What are the young companies primarily using this funding for?

Round2 focuses on young companies that are in an advanced stage of development, have approximately 20 – 100 employees and have mostly already reached operational break-even. The majority of our portfolio companies have managed to get to this level prior to Round2 funding completely without external financing. These bootstrapped companies follow a growth strategy that allows growth without high burn rates. We call this „sustainable business building“. In our portfolio there are many companies like the German cybersecurity company Myra Security, the Swiss EduTech scale-up Avallain, the Finnish multiple award-winning scale-up Vainu or the rapidly growing e-commerce fulfillment provider Logsta from Austria, which have all managed to grow to a revenue volume between 5- 15 million Euro without external equity financing. For the founders of these companies, revenue-based finance is a suitable way to accelerate the growth of their companies even further without having to relinquish control.

Revenue-based finance is used almost exclusively for the expansion of sales, marketing and internationalization. These are all measures that lead very quickly to revenue growth. The typical financing volume is initially EUR 500k – 2 million and can then be gradually increased to EUR 10 million and more, also by supplementing it with equity.