Royalties & Contingent Income
How to Underwrite Recurring Revenue (ARR) Financing
Underwrite recurring revenue financing by analyzing the quality and retention of contracted revenue. Measure gross and net revenue retention, churn, gross margin, customer concentration and burn, then size the loan as a multiple of ARR consistent with runway and recovery value. Customer cohort data matters more than profitability.
What makes recurring revenue financing underwriting different
Recurring revenue financing lends to software and subscription businesses based on annual recurring revenue rather than EBITDA. What makes it distinct is that borrowers are often unprofitable, so the lender relies on the durability of customer contracts and the value of the business in a sale. Value comes from sticky revenue with high gross margins and expanding customers. Risk comes from churn, slowing growth, high burn, customer concentration and the possibility that the business cannot reach profitability before cash runs out.
Lenders underwrite retention cohorts, unit economics and a path to cash flow breakeven, and they set covenants on liquidity and revenue. Equity investors view ARR financing as less dilutive growth capital but weigh covenants and leverage. Revenue-based financing providers lend smaller amounts repaid from a share of monthly revenue. Acquirers and sponsors value ARR businesses on revenue multiples, which supports lender recovery but can change quickly when markets reprice software companies. Lenders also test whether recurring revenue is truly contractual or month-to-month usage.
Key metrics
Annual recurring revenue
Contracted recurring revenue is the basis for loan sizing.
Lenders often size recurring revenue loans as a multiple of ARR, adjusted for retention and growth.
Net revenue retention
Retention including expansion shows whether existing customers grow or shrink.
Many lenders view net retention at or above 100% favorably.
Gross revenue retention and churn
Lost revenue from cancellations and downgrades directly reduces the loan base.
Gross margin
High margins mean recurring revenue translates into cash once growth spending slows.
Burn and runway
Cash burn determines whether the company can operate until breakeven or the next raise.
Customer concentration
Loss of a large customer can sharply reduce ARR.
How to underwrite it, step by step
- Collect ARR and customer-level revenue data by month.
- Build retention cohorts and calculate gross and net retention.
- Analyze gross margin, sales efficiency and burn.
- Review customer contracts, terms and concentration.
- Model runway and path to breakeven under base and downside cases.
- Size the loan and set covenants on liquidity and revenue.
- Monitor monthly metrics and covenant compliance.
Due diligence checklist
- ARR schedule by customer
- Monthly financial statements
- Customer contracts
- Retention and churn analysis
- Sales pipeline data
- Budget and forecast
- Cap table and equity documents
- Bank statements
- IP assignments
- Lien searches
Key risks and mitigants
Rising churn
Analyze cohorts and set covenants tied to retention or revenue.
Burn exceeding plan
Use minimum liquidity covenants and monitor monthly.
Customer concentration
Limit advance against concentrated revenue.
Market repricing of software valuations
Size loans conservatively relative to enterprise value.
Revenue recognition issues
Reconcile ARR to invoices and cash receipts.
Typical financing and deal structure
Recurring revenue loans are typically senior secured term loans sized as a multiple of ARR, with covenants on minimum liquidity, revenue or retention and conversion to EBITDA-based covenants as the company matures. Revenue-based financing provides smaller amounts repaid from a percentage of monthly revenue. Lenders take security over all assets including IP and use account control agreements. Sponsors often use ARR loans for acquisitions of software companies. Typical terms include an interest-only period, a total term of several years, and prepayment fees that step down over time. Lenders often require the borrower to keep a minimum cash balance and report ARR monthly. Facilities may include a delayed draw tranche available once ARR or retention targets are met.
Red flags
- Net retention below 100% with declining trend
- ARR that does not reconcile to invoices or cash
- High burn with no path to breakeven
- Large share of revenue from one customer
- Short contract terms with easy cancellation
Frequently asked questions
How much can you borrow against ARR?
Lenders typically size recurring revenue loans as a multiple of annual recurring revenue, adjusted for retention, growth, gross margin and burn. Higher retention and margin support larger loans. Lenders also consider enterprise value and runway to ensure the loan can be repaid or refinanced. Lenders also confirm ARR against invoices.
What is net revenue retention?
Net revenue retention measures how much recurring revenue from existing customers remains after a period, including expansion, downgrades and churn. A rate above 100% means existing customers are growing revenue overall. It is a key metric for recurring revenue lenders. Lenders review it by customer cohort to see trends over time.
How is ARR financing different from venture debt?
ARR financing is sized primarily on recurring revenue and retention, often for later-stage companies. Venture debt is sized more on equity raised and investor support. ARR loans may have revenue-based covenants, while venture debt often includes warrants and relies on future equity rounds. Pricing and covenant packages also differ between the two.
What is revenue-based financing?
Revenue-based financing provides capital repaid through a percentage of monthly revenue until a fixed amount is repaid. Payments rise and fall with revenue. It is common for smaller recurring revenue businesses and does not usually require equity or warrants. Total cost depends on how quickly the cap is reached.
Related terms
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Try Underridge freeEducational content, not investment, credit, legal or tax advice. Benchmarks are common practitioner rules of thumb and vary by lender, market and cycle.