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Recurring Revenue Financing: An Increasingly Popular Option

In today's fast-paced business environment, high-growth companies, especially in the technology and software sectors, need flexible financing solutions that can keep pace with their rapidly evolving needs. Traditional asset-based lending, which relies on hard assets like accounts receivable and inventory as collateral, often falls short for these companies. They tend to be light on those types of assets but have a different valuable asset - recurring revenue from subscription-based products and services. In recent years, recurring revenue financing has emerged as an attractive alternative, providing capital that growing businesses need to invest in expansion.

What is Recurring Revenue?

At its core, recurring revenue refers to the portion of a company's revenue that is highly likely to continue in the future. This predictable revenue usually comes from ongoing contracts and subscriptions rather than one-time sales. Common examples include:

• Software-as-a-Service (SaaS) subscriptions
• Platform-as-a-Service (PaaS) or Infrastructure-as-a-Service (IaaS) agreements
• Subscription boxes or content services
• Ongoing maintenance or support contracts

The key is that customers are contractually committed to making regular, ongoing payments. While the business must continue delivering products and services, the recurring revenue provides a level of predictability and stability to future cash flows.

Structuring Recurring Revenue Facilities

While recurring revenue financing is built on the same foundations as asset-based lending, it has several distinct features. Rather than advancing funds primarily based on a borrowing base of eligible accounts receivable and inventory, availability under a recurring revenue facility is generally tied directly to the level of recurring revenue.

The two key structural components are the "advance rate" and the definition of "recurring revenue" itself:

• Advance Rate: Typically expressed as a multiple of monthly recurring revenue (MRR) or annual recurring revenue (ARR). For example, a company with $1M in MRR might be able to borrow up to $5M at an advance rate of 5x MRR. The specific advance rate depends on the lender's underwriting and risk assessment.

• Recurring Revenue: The definition specifies exactly what counts. Usually it includes only contractually committed, highly predictable revenue streams. One-time revenue, variable fees, and revenue from at-risk contracts (e.g. month-to-month commitments vs multi-year contracts) are generally excluded.

Some key factors that impact the advance rate and definition of recurring revenue include:

• Revenue Concentration: Is the recurring revenue well diversified or is the company reliant on a few key customers? Higher concentrations generally result in lower advance rates.

• Industry/Sector: Some customer segments are "stickier" than others. For example, critical infrastructure software tends to have lower churn than a consumer mobile app. More stable industries can generally support higher advance rates.

• Growth Trajectory: Is recurring revenue growing or shrinking? A track record of steady growth can instill more confidence than a company with flat or declining revenue.

• Gross vs Net Churn: How much revenue is lost due to customers canceling (gross churn) and how much of that is offset by revenue from new customers or expansion of existing contracts (net churn)? The lower the net churn, the healthier the business.

In addition to the core structure around advance rates and recurring revenue, these facilities also incorporate many of the traditional protective features of asset-based loans - financial covenants, reporting requirements, monitoring provisions, etc. However, they are specifically tailored for recurring revenue businesses.

The Benefits for Borrowers

For the right companies, recurring revenue financing offers several compelling benefits:

• Larger Facilities: Since availability is based on total recurring revenue rather than fluctuating levels of accounts receivable, companies can often access significantly more capital than through a traditional ABL structure. This provides more dry powder for growth investments.

• More Flexibility: Recurring revenue lines are generally less restrictive than other debt alternatives. The company isn't giving up equity or control, and there are fewer limitations on how the funds can be deployed.

• Less Dilutive: Compared to raising another equity round, using debt financing can minimize dilution for existing owners and investors. This is especially appealing when equity valuations are depressed.

• Complementary to Venture Debt/Equity: Recurring revenue facilities can provide an extra layer of capital in addition to (or sometimes in lieu of) traditional venture debt or equity rounds. This allows companies to stretch their equity dollars further.

Of course, recurring revenue financing isn't a panacea. It doesn't make sense for every company and situation. The business needs a certain scale of recurring revenue to qualify, and the reporting and monitoring requirements can be onerous. There's also the ever-present risk of default if the business stumbles and recurring revenues decline. But for established companies with strong market traction, it can be a powerful tool.

Lender Considerations

From the lender's perspective, recurring revenue financing requires a very different approach and risk paradigm than traditional ABL. There's limited collateral value to fall back on, so the underwriting process is focused heavily on stress-testing the recurring revenue stream itself. Key considerations include:

• Churn Analysis: Dissecting the company's historical churn data is critical. How does churn vary across different customer cohorts, geographies, product lines, etc.? Lenders need to understand not just the overall churn rate but the specific pockets of risk and stability.

• Customer Diligence: Especially for companies with revenue concentration, the lender must underwrite the customers' creditworthiness and stickiness. They may need to review individual contracts for key terms and termination rights.

• Downside Modeling: Lenders typically model out how long it would take to recoup their capital if the company had to stop investing in growth and simply operate the business to collect existing recurring revenues. This "harvest analysis" then informs the initial structuring decisions.

• Monitoring and Covenants: Ongoing monitoring is critical since the value is tied to the recurring revenue stream vs hard assets. Detailed monthly reporting, periodic field exams, and well-crafted financial covenants provide the necessary early warning system and risk controls.

Despite the unique risks, many lenders find the recurring revenue space very attractive. Yields tend to be higher than traditional ABL, and the market has grown substantially as the software and technology sectors have boomed. The recurring revenue itself also provides a certain level of stability compared to the ups and downs of asset-based borrowers.

Market Landscape and Outlook

Over the past decade, recurring revenue financing has gone from a niche offering to a mainstream product. Most of the major commercial banks now have dedicated technology and recurring revenue lending groups. Venture debt lenders and opportunistic credit funds are also active participants. According to a recent industry report, the total market for recurring revenue financing exceeds $10B annually.

Competition amongst lenders has helped spur continued innovation and evolution in deal structures. Some key trends:

• Higher Advance Rates: In 2016, advance rates of 3-4x MRR were standard. Today, for premium credits, some lenders are underwriting deals at up to 10x MRR.

• Lower Churn Thresholds: As lenders have become more comfortable with the recurring revenue model, they've also become more tolerant of higher churn rates, especially if offset by strong retention and expansion numbers.

• Longer Maturities: The standard used to be 1-3 year facilities. Now 3-5 years is the norm, with some recent deals getting stretched to 6-7 years.

• More Flexible Structures: Originally these were mostly structured as capped revolvers. Now term loan and convertible structures are increasingly common as well.

Of course, as with all lending markets, there are cycles of expansion and contraction. Lenders may be extending at the peak only to pull back dramatically when economic conditions sour. The recurring revenue businesses themselves are also impacted by broader market forces. But the secular shift towards subscription and as-a-service business models provides a strong continuing tailwind for the foreseeable future.

Conclusion

Recurring revenue financing has proven to be a valuable growth accelerator for a certain profile of companies - those with high growth trajectories but limited hard assets, often in the technology and software realms. It's a unique structure that requires specialized knowledge to execute well for both borrowers and lenders. But as the product continues evolving to keep pace with the market's needs, its importance as a source of capital is only poised to grow further. Whether through bank lenders, venture debt providers, or other sources, expect to see recurring revenue financing remain center stage in the coming years.