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