Lateral Capital Management, LLC

Royalty-Based Financing: Strengths and Drawbacks

Royalties are a well-understood financing structure in music, electronics and other technologies.

The advantages of Royalty-Based Financing (RBF) can be compelling for investors and certain types of companies. There are some downsides, of course, and both investors and entrepreneurs should take them into consideration. Remember, our thoughts here are no substitute for professional advice.

What is Royalty-Based Financing? – In a nutshell, the investor (Lender) advances money against a revenue stream which the company (Borrower) is relatively certain of receiving. In return, the investor is promised they will receive a fixed IRR or dollar-based return. Generally, the “cost” of this money to the Borrower approximates that of an equity investment (25-30% IRR to the Lender) – with the advantage that the term is fixed and in the control of the Company/Borrower.

The best example of RBF would be payments from a licensee of the Borrower, where the company has agreed to out-license some of its intellectual property in return for an ongoing payment based on percent of sales. Typically, these licenses have minimum payments attached to them which are paid annually to the licensor; often by big, well-financed licensees. In these situations, the Investor/Lender would be pretty certain that some money will come into the company and be credited to them.

Assuming the licensee is reputable, investing against a contract which pays the Investor/Lender as license fees are received by the Company/Borrower should be pretty safe – even if the Company itself is not yet profitable. The timing here can be left open: The Investor/Lender receives some or all of the license revenue stream until their capital is returned – plus enough money to produce an agreed upon return.

Why is this Attractive? –  Royalty-Based Financing can be seen as a “safer” way for the Investor/Lender to get a return they will be happy with. They really don’t care what else the company does, so long as there is relative certainty that they will be paid back as License or Royalty revenues come in the door. For a compelling stream of license revenue, 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 Company/Borrower, RBF has one huge upside: it can bring much needed cash in the door without giving up equity. While the cost is generally higher than traditional bank debt, it can be more attractive then raising equity. The rest of the company’s assets may not need to be encumbered if the Investor/Lender is willing to rely entirely on the licensees’ ability to pay the guaranteed minimum license fee.

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 agreed to upfront – 30%, for example – and the company ends up to be the next Google, that’s all the return the investor will receive.
  • Uncertain Period – If the Royalty-Based revenues are tied to product sales (“$100.00 returned for every widget sold”), investors are at the mercy of the market. No one can know for sure how long it will take for capital to be returned, if ever. This is why stable, predictable revenue streams from licensees may be a preferred approach.
  • Tax Status – From the standpoint of taxing authorities, Royalty-Based Financing could be seen as a loan. This may also disqualify angel investors from claiming angel tax credits, because they can’t claim tax credits on a loan and the returns may be deemed as interest income, on which income tax rates will be paid.

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 borrowed to fund marketing and sales activity, for example, for a finished product. But if the company needs every dime? Perhaps going after more equity is a better approach.
  • Non-Committed Capital – Opponents of RBF stress that royalties are based on a percentage of revenues. The company has to make royalty payments even if it’s not profitable. This can end up eating into operating capital.
  • More Liabilities – Royalty-Based Financing is usually carried on the Balance Sheet as a secured loan. RBF investors have rights that are similar to those of traditional creditors. If there’s a change of control, for example, investors will want their unpaid return to be paid off the top.
  • 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 the debt. If the company defaults on repayments, it can be forced to liquidate other assets in order to repay the entire advance.

IMPORTANT DISCLAIMER – This material is for general information only. These are general perspectives on a very complicated, sophisticated area of finance. It is not to be construed as Legal, Tax, Accounting or Financial advice. Readers are urged to consult professional resources before entering into any kind of RBF agreement.