Royalty-Based Financing as a New Tool for Start-Up Financing?

With the market still in flux, raising capital for companies — whether equity or debt — remains a challenge. One innovative vehicle for raising capital that is generating attention in the market lately is royalty-based financing.

At its simplest, royalty-based financing is lending against the company’s future revenue stream but, in the venture context, it can have a few wrinkles. Instead of purchasing an equity interest in a company, the investor lends the company a set amount of funds, just like a regular loan. Repayment, however, can be structured with more flexibility than a loan. For example, the company could make repayments that are calculated solely as a percentage of the company’s revenue stream over a period of time. Or the loan could carry a set interest rate and payment schedule in addition to the revenue component. In this structure, the company may pay interest only for a period of time (e.g., a year or two) and then repay the principal and interest on the loan based on a set amortization schedule, plus a percentage of the company’s revenue stream, over the same time as the set loan repayment. Under either scenario, the total repayment to the investor is capped at a certain amount (e.g., three times the original loan amount). With either structure, the investor has a guaranteed return on the loan since the investor will receive a check every month and will participate in a percentage of the revenues as they increase over time.

To illustrate how royalty-based financing works, suppose a company needs a $1-million investment. It is possible that the company could find an investor willing to lend the money on a 10-year repayment plan with an interest-only repayment in the first year, principal and interest repaid in equal monthly installments over the next nine years and, perhaps, payments of three percent of the company’s monthly revenues during that same nine-year repayment period. The investor would reap a return on principal, together with interest and the royalty amount, and the company will have achieved fairly low-cost financing without giving up any equity in the company. This same repayment scenario would play out even if the loan did not have an interest component to it, but if it just involved repayment of the loan based on a percentage of the company’s revenues. In this context, the same $1-million investment may require a longer repayment period, and the revenue stream to the investor would be more susceptible to swings in the company’s revenues. On the other hand, without the interest component, the repayment of the $1-million investment carries less risk of default since all payments to the investor are from the company’s revenues. Under either structure, it appears to be a win-win for all. And, if like many of these royalty-based financing investors, the investor takes a warrant for a small equity position, the investor could see some additional reward from a future sale or IPO of the company without taking any additional risk.

This vehicle is starting to gain attention in this difficult economic environment since it does have a number of benefits.

• It eliminates the need for the investor and the company to agree on the company’s value at the time of the investment and it eliminates the need for there to be a single liquidity event in three-to-five years. Thus, two of the most typical areas of contention between the company and the investor are removed.
• The founder of the company does not suffer much dilution as the dilution comes only from the warrant position. However, there will be some loss of control despite the minimal dilution since, like all lenders, the investor will want some approval rights on major actions that could impact the repayment of its investment.
• There is a certain return on investment for the investor, which is particularly appealing for those investors who need to show returns to their limited partners quickly in an environment where other exit scenarios are unlikely.
• Depending on the investor, which could be a private equity fund, the company could still obtain operational experience and mentoring from the investor. There are several funds dedicated to making these types of investments.

Even with these advantages to royalty-based financing, not all companies would want to pursue this vehicle for a variety of reasons, including:

• Many investors do not want to be capped on the possible upside returns if the company does have a significant liquidity event. Nobody would have wanted to invest in Google through royalty-based financing and not reap the huge financial gains that all of the other investors realized. While investors could alleviate this downside by receiving a warrant in the company, the upside associated with the warrant will be much smaller than what a traditional equity investor would otherwise receive in a liquidity event. And most investors do assume a significant return when making an investment — they do not enter the investment expecting failure.
• The company itself is not reinvesting all of its available cash towards future growth, research, and development since it is using some of that cash to repay the royalty-based financing.
• Royalty-based financing, particularly when it is structured so that the repayment schedule is derived solely as a percentage of the company’s revenue stream, works best for those companies that already have a product in the market and the product has a high gross-profit margin. Early-stage companies without products in the market generally will not have this vehicle as an available option.
• Royalty-based financing is still, at its core, a loan. If there is a default in repayment, the royalty-based financing investor can foreclose on assets of the company.
• The company does not gain a source of committed capital from the investor that will help the company grow. With a venture fund investor, the investor will typically be available to help the company not only operationally, but also for the company’s future financing needs.

In the end, the royalty-based financing vehicle is likely a good arrangement for a small- to mid-size investment amount for a company that already has a product in the market. While this type of financing arrangement is unlikely to replace venture equity investments, it can provide an alternative financing source and structure for some companies.

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If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individual:

Beth J. Felder
Boston, Massachusetts
617.342.4065
bfelder@foley.com