Recurring Revenue Loan: Is It Right for You?

For entrepreneurial medical device companies in growth mode, liquidity is key. Research and development activities require capital—and lots of it—usually long before a company has begun to turn a profit. But because bank financing is based on earnings before interest, taxes, depreciation, and amortization (EBITDA), companies that aren’t yet EBITDA-positive may find it difficult to secure traditional funding.

For companies that have a stable base of recurring revenue (such as subscription- or other membership-based income), a recurring revenue loan may be a good alternative source of financing. Recurring revenue loans provide an infusion of cash with little or no demand for principal repayments and prepayments up front, giving a company the liquidity boost it needs to pursue an aggressive growth strategy. These loans come with certain limitations and high interest rates, so it is important to make sure your company is a good fit for this alternative financing model.

Key Characteristics of Recurring Revenue Loans
Recurring revenue loans first emerged in the technology sector around 2016, and by 2019 they had become prevalent in the health and life sciences industries as well. Alternative lenders such as business development companies and credit funds recognized recurring revenue loans as a creative way to secure a yield on their assets. Instead of structuring the financing on a multiple of EBITDA, alternative lenders base these loans on a company’s subscription-based revenue (for software as a medical device, for example) or other recurring revenue feature.

Recurring revenue loans are specifically structured to allow a company to pursue rapid business growth, rather than having to repay the principal quickly. Unlike a traditional financing, the amortization schedule for a recurring revenue loan is either very small or nonexistent. Interest is typically paid-in-kind (meaning it is added to the principal amount) rather than cash. Similarly, recurring revenue loans do not include an excess cash flow mandatory prepayment. These loans are therefore an excellent fit for companies with a high cash burn rate and a high need for liquidity.

Another benefit to recurring revenue loans is that unlike venture capital financing, they do not dilute a company’s equity. This feature may appeal to founders and entrepreneurs who wish to retain full ownership in their company and full control over its future direction and growth.

In return for this high degree of flexibility, lenders typically charge a high rate of interest for recurring revenue loans. They also expect a company to successfully execute its growth strategy to become profitable and have positive EBITDA within a specified timeframe. Typically, after two to three years, a recurring revenue loan will “flip” to standard EBITDA-based terms. A company considering a recurring revenue loan should have a strong growth model in place to avoid risk of default.

In addition to high interest and a flip to an EBITDA basis, recurring revenue loans typically include strict negative covenants. Negative covenants prohibit a company from engaging in certain activities during the loan term, such as incurring or issuing new types of debt, or incurring liens or encumbrances on the company’s assets. Because of the high-risk nature of recurring revenue loans, their negative covenants are usually much more stringent than those of traditional loans. Lenders want to encourage recipients to use the liquidity to achieve their growth objectives, rather than pursuing other side projects that may affect the profitability timeline.

Bottom Line
For the right company, a recurring revenue loan can provide the capital necessary to fuel research and development and other high-growth activities. To make the most of a recurring revenue loan and minimize risk, a company should have stable recurring revenue, a strong and actionable plan for achieving profitability, and full buy-in to the lender’s requirements and timeline. 

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Stephanie McCann is a partner and co-head of the finance practice group at McDermott Will & Emery. She represents private equity groups, commercial lending institutions, and major public and private companies in connection with the structuring, negotiation and documentation of domestic and international secured and unsecured financing transactions. Stephanie is a current member of McDermott’s Executive and Management Committees.