Customer Funded

Happy Thursday morning! I’m Jason, this is INTRO to Finance, and this week we’re taking an old saying and giving it a new spin.

The saying? Customers are the absolute best source of funding.

Revenue from customers is this magical form of renewable non-dilutive funding for your business. But did you know that the magic of customers doesn’t stop there? 

In this week's ItF issue, we’re going to explore the question:

How can the quality and relationships of my customers help me unlock further funding for my business?

Any company that has talked to a capital provider knows the relationships with your customers are critical for raising capital. Sure, the customer and revenue growth are an indicator of whether you’re on to something, and can validate that you have found some form of product-market fit. However, your customers are more helpful than a reference call or a singular number on your P&L. They’re real assets for your business, and they can help you access capital.

Today we’re going to talk about the many types of customers and relationships that can help you receive funding. We’ll also provide some examples of financings that are most applicable to the customer relationships we explore.

A Customer Who Owes You Money

The strongest indication that a customer loves your product is when they agree to buy it. However, not everyone pays you as soon as the product or services have been delivered. This is especially true for larger customer payments. But having an invoice outstanding from a customer isn’t all that bad. It’s the next best thing to immediately receiving the cash. 

You may experience frustrating bottlenecks for growth by not having that cash today, but the amount of money that a customer owes you - or Accounts Receivable - opens up an opportunity for financing. Financiers can advance you the money with the prospects that the customer will pay you shortly. Additionally, you’ve already delivered the goods or services and have a legal claim to payment from the customer. This short wait before payment, and the legal claim, provide financiers comfort that they’ll get their money back. 

These arrangements typically come in two different forms:

1. Factoring
   This is selling an individual customer payment at a discount. 

   1. Example: You receive $40k today from a financier on a customer account that expects to pay $50k in 90 days. Once the customer ultimately pays the full $50k, the lender will keep a fee and return the rest to you.

2. Accounts Receivable Line of Credit
   The financier provides a % of all expected Accounts Receivable payments.

   1. Example: You have $1M in expected customer payments. The lender provides you with 80% of your Accounts Receivable ($800k) as a buffer in case some customers don’t pay. The amount you can borrow changes based on how much is owed to you in Accounts Receivable. The financier charges you interest for the amount that you borrow. 

Certainly there are instances in which customers never pay. It can create some issues for your company depending on how your arrangement is structured. Financiers will try to mitigate this risk by only giving you money based on customers who are more likely to pay. However, if the customer doesn’t pay, the business may be held responsible for making sure the capital gets paid back to the financier.

There are some situations where the lender takes all the risk of a customer not paying – such as non-recourse factoring agreement. But these arrangements can be expensive to the business and should only be used if you truly need to accelerate customer payments.

Accessing financing based on your Accounts Receivable is nothing new. There are countless capital providers doing this – including the most conservative financiers: banks.

A Customer Who’s Expect to Continue Paying You

The proliferation of subscription and recurring revenue businesses has changed the way financiers think about leveraging customer relationships to provide capital.

Many businesses that have recurring revenue have little-to-no Accounts Receivable, because customers pay at the time of service, or, even better, pay in advance. While you haven’t already rendered services, the ongoing payments from customers can provide confidence that you can pay back the financing amount. The two major indicators that give the financier comfort are the legal claim you have on the payments and your ability to keep them as a customer. 

The stronger the claim you have on future payments, the easier it is to convince a financier to provide funding. Any agreement that contractually requires the customer to pay for a period of time can help convince a capital provider that payments will continue. Regardless of whether or not they sign a contract, you’ll run into problems if they don’t renew or decide to cancel. Customer Churn - the loss of paying customers - can create a problem for paying back the financing. Using financing based on ongoing payments from customers who only stick around for a short period of time can feel like putting water into a leaky bucket. 

If you do have the predictability of ongoing revenue, there’s been a rise in financial options for your business. Both banks and independent financiers have been crafting new products to fit recurring revenue business models. A couple examples:

1. Revenue-Based Financing
   Instead of set payments, companies pay a fixed percentage of ongoing revenues. The payments increase and decrease based on business revenue. These payments continue until the initial amount, plus a multiple (also known as a cap), is repaid.

   1. Example: You receive $100k from a financier and agree to pay 5% of monthly revenues until you pay back a total of $150K.

2. Recurring Revenue Line of Credit
   A financier provides a multiple of your monthly recurring revenue. 

   1. Example: You agree to a 3x multiple with the financier and have access to a $1.5M line of credit. This is based on 3x your $500k in monthly recurring revenue. This changes each month. The financier charges you interest for the amount you borrow. 

Both options can be great non-dilutive capital for your business. RBF can be especially helpful for businesses that are nervous about signing up for specific monthly payments. But paying a fixed percentage of revenue can have negative implications in certain situations. The larger the business gets, the larger the payments become. If you’re rapidly growing and pay back the financing in a short period of time, the capital could be expensive relative to other financing options.

A Customer Who Makes a Financier Nervous

While there are certain customer relationships that can help you woo a capital provider, some customers can make them nervous. Financiers typically structure the financing to contemplate or exclude these types of customers:

• International Customers
  The difference in the law and complexity of international payments can create concerns depending on the country. 

• Customers That You Owe
  Financiers are giving you money expecting to get money in return. If you’re ultimately having to pay the customer, that payment could decrease the lender’s chance of getting paid. 

• Concentration
  Customers who make up a large portion of your revenue can cause concern if the financier is relying heavily on a few customers to pay. (Note: factoring is a good option here).

• Procrastinators
  If your customer has taken longer than 90 days to pay, or has a history of waiting a long time to pay, financiers may choose to avoid the rollercoaster of waiting to see when the customer decides to pay. 

These aren’t absolute rules, and it doesn’t mean these aren’t great customers. Each financier has their own tolerance to each element, but all of them introduce a bit more risk.

Customers Help You Get More Customers

While they might not be as obvious as large buildings or valuable equipment, the relationships you build with your customers are the most valuable asset you have in your business. Not only is revenue a non-dilutive funding source you can turn into profits, the customer relationships behind that revenue can unlock all kinds of financing options for you as your business grows.

Happy customers building a foundation for many financing options to fund getting more new happy customers is our kind of virtuous cycle.

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Have a question on funding options or looking to understand more about finance? Let us know!