Recession in Startups on Revenue
What a downturn in the economy would mean for revenue
L ast year, revenue-based financing providers received millions of dollars from venture capitalists for their alternative financing, known as “founder friendly”. Having said that, do you believe that they still will be your friend with the increased lending risk?
Let’s get into more details.
Revenue-based financing providers provide e-commerce and SaaS startups with an alternative to VC funding. They have become popular in recent years. Since 2017, 18 RBF providers have emerged in Europe, raising a total of $671 million from venture capitalists.
However, as we can see, lending to startups is about to become much riskier. RBF providers are vulnerable to interest rate fluctuations and rely on their clients’ strong revenues. That results in suffering if their lending portfolio suffers.
Layoffs have begun in the sector and players who are small in scale have stopped lending entirely. Larger RBF firms have stated that they are looking for acquisitions due to the fall in valuations.
Most of them were at the top of the credit cycle, making it easier for them to get credit and spread more esoteric forms of financing. But once the tide goes out and hits on recession, what they will have to see is a lot of lenders swimming without trunks. So, the unavoidable question arises again. How did they build a portfolio with such a high default rate?
- The Risk
The revenue-based financing business model, which was offering companies a loan upfront, to be repaid as a percentage of future monthly revenues had been working well during 2020. But that was when the SaaS startup market was worth $145 billion and annual revenue had increased by 78% on average.
You must admit that it is a riskier venture than traditional secured loans. The main reason would be that the traditional loans are backed up by assets such as collateral if the debtor fails to repay the loan. If the client default, RBF providers lack such collateral.
As we all have heard, when the credit cycle is at its peak, it’s easier to get credit and do whatever type of lending you desire. According to the experts, when there is a hint of a crisis, unsecured credit creates trouble always because there is nothing to back it up. They have further stated that when that happens, you will have to see your clients’ revenues no longer be guaranteed, and you have no assurance they will pay you back.
- Risk Management
Forward Partners, a London-listed venture capital firm, released its 2021 annual results last week, including those of its RBF arm, Forward Advances.
Total write-offs at Forward Advances had reached 8.4 percent of its 2021 cohort of loans, owing primarily to defaults on three unnamed accounts. It attributed the high level of write-offs to its rapid growth and stated that it had put mitigations in place to reduce write-off risk going forward. This includes strengthening its technology, utilizing new data sources, and implementing additional governance measures.
Most RBF providers say that the defaults are not yet exceeding forecasts. But reports are saying that they are monitoring the situation closely. Nobody can blame them as the macroeconomic situation changes.
Some of the RBF providers have stated that the default rates are decreasing. So, it might be an advantage of having more historical data on companies and the market. Because that makes it easier to determine which clients are at risk.
- It’s time to Reconsider!
Clearco, the best-funded RBF startup active in Europe, based in Canada, has been impacted by the market downturn. It had to lay off 10% of its employees at its European headquarters in Dublin in June, just two months after announcing 125 new jobs there.
Likewise, most of the top, best-funded European-based players in the market, had laid off considerable percentages of their staff during the past few months. It has been said that the RBF model has turned them off because companies that use it do so due to a lack of alternatives. That will result in a lot of adverse selection, becoming quite unstuck with a recession. Higher interest rates are to be said to make the model much more difficult to extract value from the players. That will be the reason for a rise in liabilities. That ends up in maintaining their balance sheets in a more expensive process.
It is no doubt that most RBF providers are having difficulty raising enough funds to make loans. According to investors, small-scale players have already stopped lending entirely due to a lack of capital. Those who have recently raised funds are looking to acquire smaller, less valuable competitors.
We don’t have to mention this because you must already know that Outfund has bought Clicfunds in Spain last year to enter the Spanish market. Levenue has bought Requr in Amsterdam in January. Outfund’s founder has stated last month that the company was acquiring a smaller German competitor.
- Diversification of one’s Portfolio
RBF startups typically lend to businesses with recurring revenue, such as e-commerce or software-as-a-service (SaaS). It is going to be risky to have a narrow portfolio focus with consumer spending on the decline and startups cutting back.
Because retail and SMEs are closest to the epicenter of the economic crisis, some of these companies will shift their sector strategy to other sectors. But that is only an assumption.
With a lending portfolio that is primarily comprised of e-commerce companies and SME retail, some companies say that it is better when the clientele is more diverse. But most of them have a half-SaaS or entirely SaaS lending portfolio.
If we are to provide you with an example, Silvr, which has raised $20.6 million in Series A funding in February, had already spread its risk across both categories. It invests 80 percent of its funds in e-commerce and SaaS companies, with the remaining 20 percent going to mobile applications.
Most of Europe’s RBF providers’ loans are designed to be paid off within a year, allowing them to shift their portfolios quickly. If the loans are underwritten correctly and if it is possible to realize a certain type of company is going to be less profitable in the future, things should be better than expected. It would be simple to run the book and get the money back, then choose what kind of business to lend to next.
However, if there are losses in the portfolio, it becomes a problem. People overlook the fact that lending businesses are inherently leveraged. A single blunder can have a tenfold or even a hundredfold impact.
- Is it necessary for revenue-based financing startups to pivot?
Revenue-based financing startups may also decide to offer complementary services such as inventory financing and data provision.
To mention some of the incidents, Clearco had started offering inventory financing and had a matchmaking service to facilitate M&A between its portfolio companies. Uncapped had been announcing their plans to enter bu
siness banking and they even hired some of the experts in business banking, especially to take it global. However, those plans have been scrapped, and the companies have stated that there will be some product announcements in the next quarter. Those are to be specifically designed to help online businesses navigate economic uncertainty.
According to investors, these companies’ loans are relatively short and that gives them confidence. once the year is up, RBF providers with sufficient capital can survive. This could imply that the RBF market does not do a lot of work in a year.
Some have negative views on the underlying loans, but not on the market as a whole. Because while smaller players disappear entirely, larger players find a way to navigate. The market environment is always changing and that’s the advantage of being fintech rather than banks.