By: Elizabeth Sloop
In a revenue-based financing (“RBF”) transaction, a business raises capital by paying investors a percentage of the gross margin in exchange for their investment.[1] RBF differs from both debt and equity financing and is generally considered to be a hybrid between these two traditional methods of raising capital.[2] Because RBF is uniquely situated, adopting characteristics of both debt and equity, it allows increased flexibility for the repayment terms as compared to traditional financing methods.[3] As a result, RBF is an increasingly popular alternative capital-raising method, especially for smaller businesses that may lack collateral for debt financing and may wish to retain ownership and control.[4] RBF can also be an attractive option for lenders because it has the potential to be very profitable.[5]
The Southern District of New York has ruled in a series of cases involving the federal Racketeer Influenced and Corrupt Organizations Act (“RICO”) and state usury claims against RBF providers in recent months.[6] In each case, the court engaged in a characterization analysis of the RBF agreement at issue to determine if the claims could proceed.[7] The claims alleging RICO and usury law violations would move forward only if the court found that the transactions were indeed loans.[8] If, on the other hand, the transactions were future revenue sales, there would be no basis for the claims.[9]
In three of the four recent cases, the court sustained claims against RBF providers, finding that the transactions were loans.[10] In determining whether the agreements constituted revenue sales or loans, the court analyzed factors including the presence of a reconciliation provision, indefinite term, and lender recourse in the event of bankruptcy, though these factors in the agreement are not dispositive.[11] Ultimately, the economic substance of the transaction, determined by an examination of the risk allocation of the deal, controls in characterizing the transaction’s status as a sale or a loan.[12]
In the fourth case, the court found in favor of the RBF provider, holding that the agreement at issue is not a loan “because Defendant is not absolutely entitled to repayment under all circumstances.”[13] Additionally, the court found that the agreement at issue contains a reconciliation provision, has an indefinite term, and does not establish recourse in the event of bankruptcy.[14] By analyzing the agreements’ provisions in detail in this series of cases, the court provided insight into how it interprets RBF agreements that it may recharacterize as usurious loans, and this insight arguably informs RBF providers’ best practices in drafting agreements.[15]
Especially considering the increased presence of RBF in the market, it is important for all parties, including both financers and businesses looking to raise capital, to understand the risks involved with this type of largely unregulated financing.[16] Businesses need to carefully consider the terms of the RBF agreement to understand whether the transaction may be a predatory loan in substance, disguised as a revenue sale.[17] Meanwhile, RBF providers need to be aware of the risk that their financing arrangements may be recharacterized as loans in order to limit their exposure to RICO and usury claims.[18] Based on the insight provided by the court in this series of cases, RBF providers should ensure that the terms of their agreements resemble true sales, not loans, by using drafting tools such as reconciliation provisions, indefinite terms, and proper risk allocation to avoid liability under RICO and state usury laws.
[1] See Adam Hayes, Revenue-Based Financing, Investopedia (June 26, 2021), https://www.investopedia.com/terms/r/revenuebased-financing.asp.
[2] See David E. Fialkow & Peter M. Ayers, The Growing Trend of Revenue-Based Financing and Its Legal Implications, K&L Gates (Sept. 22, 2022), https://www.klgates.com/The-Growing-Trend-of-Revenue-Based-Financing-and-its-Legal-Implications-9-22-2022 (“One expanding alternative is revenue-based financing…which takes on some characteristics of both [debt and equity].”).
[3] See Nick Chandi, Should Your Company Offer Revenue-Based Financing Options?, Forbes (Aug. 10, 2022, 8:00 AM), https://www.forbes.com/sites/forbesfinancecouncil/2022/08/10/should-your-company-offer-revenue-based-financing-options/?sh=3fde48f33dcd.
[4] See id.
[5] Id. (“It [RBF] improves loan accessibility to businesses and the rate with which lenders can choose borrowers, and it allows lenders to serve more loans.”).
[6] See Fleetwood Servs., LLC v. Ram Cap. Funding, LLC, No. 20-cv-5120 (LJL), 2022 WL 1997207, at *8 (S.D.N.Y. June 6, 2022)(involving RICO and usury claims); Haymount Urgent Care PC, v. GoFund Advance, LLC, No. 22-cv-1245 (JSR), 2022 WL 2297768, at *5 (S.D.N.Y. June 27, 2022)(involving RICO claims); Lateral Recovery LLC v. Queen Funding, LLC, No. 21 Civ. 9607 (CGS), 2022 WL 2829913, at *4 (S.D.N.Y. July 20, 2022)(involving RICO and usury claims); Streamlined Consultants, Inc. v. EBF Holdings LLC, No. 21-CV-9528 (KMK), 2022 WL 4368114, at *3 (S.D.N.Y. Sept. 20, 2022)(involving usury claims).
[7] See Fialkow & Ayers, supra note 2.
[8] See id.
[9] See id.
[10] See Fleetwood Servs., LLC, 2022 WL 1997207, at *20; Haymount Urgent Care PC, 2022 WL 2297768, at *8; Lateral Recovery LLC, 2022 WL 2829913, at *5; see also Katherine C. Fisher, SDNY Sustains RICO Claims Against Revenue-Based Financing Companies, Hudson Cook (July 30, 2022), https://www.hudsoncook.com/article/sdny-sustains-rico-claims-against-revenue-based-financing-companies/.
[11] See Fleetwood Servs., LLC, 2022 WL 1997207, at *9 (“The three factors provide only a guide to analysis. They do not dictate the conclusion, and a court need not find the presence of all three factors in concluding that a transaction is a loan.”).
[12] See Fleetwood Servs., LLC, 2022 WL 1997207, at *10; Haymount Urgent Care PC, 2022 WL 2297768, at *7; Lateral Recovery LLC, 2022 WL 2829913, at *4.
[13] Streamlined Consultants, Inc., 2022 WL 4368114, at *4.
[14] Id. at *4-5.
[15] See Fleetwood Servs., LLC, 2022 WL 1997207, at *8-13; Haymount Urgent Care PC, 2022 WL 2297768, at *6-8; Lateral Recovery LLC, 2022 WL 2829913, at *3-6; Streamlined Consultants, Inc., 2022 WL 4368114, at *4-5; see also Robert F. Gage, SDNY Holds that Revenue-Based Financing Contract is Not a Loan, Hudson Cook (Sept. 30, 2022), https://www.hudsoncook.com/article/sdny-holds-that-revenue-based-financing-contract-is-not-a-loan/ (“[T]he U.S. District Court for the Southern District of New York has…given the industry valuable guidance that should be required reading for those who craft revenue purchase agreements.”); Fisher, supra note 10 (“Each decision provides guidance on how to mitigate risk by updating contracts or adopting best practices.”).
[16] See Fialkow & Ayers, supra note 2.
[17] See Sandra Mardenfeld, Using Revenue-Based Financing to Grow Your Business, Bus. News Daily (June 29, 2022), https://www.businessnewsdaily.com/6659-revenue-based-financing-tips.html.
[18] See Fialkow & Ayers, supra note 2 (“To avoid costly litigation and exposure, financers should take care that their products do not take on the characteristics of loans.”).
