Cost is often a big determining factor when small business owners decide what financing option is right for them. Annual percentage rate (APR) is used to determine the total cost of a traditional bank loan. However, with revenue-based financing, a factor rate is typically used to determine the total cost of the funding. Here we’ll explain why APR isn’t a good way to calculate the cost of revenue-based financing, what a factor rate is, and how to calculate the total cost of this financing product.
Why is APR not an accurate way of calculating the cost of revenue-based financing?
Annual Percentage Rate (APR) is calculated based on variables typical of a loan, such as fixed payment amount and a fixed payment term. These variables do not apply to revenue-based financing, because the payments are not fixed (they can be adjusted downward if business revenue decreases), and the estimated payment term is not fixed either (if payments are reduced, it would lengthen the duration of remittance or estimated payment period). Therefore, APR cannot be used to accurately reflect the cost of revenue-based financing in the same way it’s used for traditional bank loans. This is why revenue-based financing providers typically use a factor rate to determine the cost of funding instead.
What is a factor rate?
A factor rate is a multiplier, expressed as a decimal, that’s applied to the funding amount to determine the total payment amount. The factor rate is determined through an underwriting process, which takes into account the risk associated with providing funding to a business and is typically based on the business’s revenue, growth potential, and other factors.
What’s the best way to calculate the total cost of revenue-based financing?
The total cost of a new round of revenue-based financing is equal to the total amount of revenue the customer agrees to remit to Capital Funds (“Amount Sold” in our funding agreement) minus the amount deposited into the customer’s bank account (“Net Purchase Price” in our funding agreement).
In a renewal transaction, a portion of the working capital Capital Funds provides (“Purchase Price” in our funding agreement) is used to pay off the original round of funding and therefore subtracted from the amount that Capital Funds deposits into the business’s bank account (“Net Purchase Price” in our funding agreement).