What is Royalty-Based Financing?

 In

Like any other financial tool, Royalty-Based Financing (RBF) of Early Stage Companies (ESC) has strengths and drawbacks. The advantages can be compelling. As we have learned from a couple of these deals, however, there are also some downsides. Both investors and entrepreneurs should take them into consideration. Remember, our thoughts here are no substitute for professional advice. You should not rely on anything we offer as legal or accounting advice.

What is RBF? In a nutshell, the investor advances money against a revenue stream which the company is relatively certain to receive. Basically, the ESC pledges that revenue to the investor, with or without guaranteeing it with money from other sources. In return, the investor receives a fixed rate of return on their money; one which is about equivalent to an equity return. The rate is negotiable, but investors would typically look for a 25-30% IRR.

A simple example of this structure would be a pledge of payments from a licensee, where the Early Stage company has agreed to out-license some of its intellectual property. Typically, these licenses have minimum payments attached to them which are paid annually to the ESC licensor. If the licensee is financially strong, and the license contract is well written, the investor would be pretty certain of seeing their money returned, with an “assured” return, over time.

Why Is This Attractive to Both Parties? Royalty Financing can be a “safer” way for investors to get a return they will be happy with. Sometimes, they don’t even care what else the company does, so long as there is relative certainty that the payment stream they are relying on will come in the door and be forwarded to them. For a steady stream of license revenue, or even a shipment-based security (“You pay me $1.00 per unit you ship … from now until I get a 30% IRR on the money I advance to you”), this may be quite a comfortable proposition. And it can be done without extensive due diligence or painful arguing about the company’s valuation. For the entrepreneur, RBF has one huge upside: it brings much needed cash in the door without giving up equity.

Downsides For Investors

  • Capped Returns – Investors who are used to “swinging for the fences” may cringe at a more certain, but fully capped return. If the payout is capped at the IRR you agree to upfront, and then the company ends up to be the next Sales force, the investor may not be very happy.
  • Uncertain Period – If payments are from product sales, investors are at the mercy of the market and no one can know for sure how long it will take to receive their full return. This is why stable, predictable revenue streams are typically one of the investment criteria for the Royalty-based approach.
  • Tax Status – From the standpoint of taxing authorities, Royalty based financing could be seen as a loan. This may disqualify angel investors from claiming angel tax credits, because you can’t claim tax credits on a loan. Also, royalty payments would typically not be taxed as capital gains, but at regular income tax rates.

Downsides For Early Stage Companies:

  • Growth Impediment – Instead of investing all of its cash in future growth and R&D, the company has to use some of the cash to make regular royalty payments. This may be fine if the company is using the money to fund marketing and sales activity – say if the product is shipping and the Royalty cash is being used to support more sales people. But if the company needs every dime? Perhaps going after more equity is a better approach.
  • Non-Committed Capital – Opponents of RBF agreements stress that some royalty payments are based on a percentage of revenues, say 10% of net sales for three years. In this case, the company has to make royalty payments even if it’s not profitable. This ends up eating into operating capital.
  • More Liabilities – At its core, royalty-based financing is a loan. This means that instead of what would otherwise be an equity investment, investors have rights that are similar to those of traditional creditors. If there’s a change of control, for example, investors may want their unpaid return off the top – with an early payment penalty which delivers their total projected return.
  • Risk of Default – Unlike traditional equity financing in which returns are based on capital appreciation, Royalty-Based Financing is a loan that relies on repayment of a debt-like instrument. If the company defaults on repayments, it might be forced to liquidate assets in order to repay the entire advance.
  • Lower Valuation – Royalty contracts are recorded as debt in the financials, which will lower the company’s valuation should it decide to raise additional money to grow or survive. So if the company doesn’t have the money to make regular Royalty payments, it might have no choice but to sell equity at a lower valuation.

Like everything else in Early Stage investing, there is no right or wrong. It all depends.

 

IMPORTANT DISCLAIMER – This material is for general background only. It is not legal or accounting advice. Readers are strongly encouraged to seek the advice of qualified legal and/or accounting counsel before acting on any information contained herein.

Print