Definition of Royalty Financing
Royalty financing is an investment vehicle where the investor lends money to investees against its future revenue streams. ((Venture Hype, Angel Investing: Components of Royalty Based Investment Model, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-exploring-angel-investment-model/.)) The investor is repaid via royalties, a regular stream of payments that are typically calculated based on a percentage of the company’s gross revenue. ((Id.)) Since repayments are based on a percentage of revenues, they fluctuate with the revenues. Investor’s returns are sometimes capped at an agreed-upon multiple of the original investment. Generally, this method of financing is most appropriate where a business has a large enough profit margin so that it can sustain a loss of a percentage of revenue over time, and still be able to cover the revenue-based payment and all business expenses. ((Venture Hype, Royalty Based Financing: What’s in it for Entrepreneurs (July 26, 2011), http://venturehype.com/royalty-based-financing-entrepreneurs/.)) Also, Royalty financing is well-suited for investees in the beginning stages that have a solid growth plan, and an established, reasonably predictable revenue stream. ((Venture Hype, Royalty Based Investment Works Best on These Companies, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-works-companies/.))
Advantages for Investors and Investees
Firstly, investors can obtain returns as soon as the investees reach an agreed upon certain revenue threshold or when the investee starts generating revenue. Hence, investors can obtain returns faster than traditional equity investments such as initial public offerings or mergers where they would usually see returns after five to ten years. Secondly, investors can obtain reliable and regular returns even if the investee is not profitable. Thirdly, the risk of default is lower because the payments are more flexible as they are not fixed on a strict schedule. Fourthly, in the event of a default, investors have a higher priority over equity holders. Fifthly, investors are guaranteed a specific amount of return on their principal and interest.
The greatest advantage for investees, on the other hand, is that royalty financing is an investment vehicle that does not depend on exits or equity ownership, and thus investees can maintain ownership and the initial mission. ((Venture Hype, Royalty Based Financing: What’s in it for Entrepreneurs (July 26, 2011), http://venturehype.com/royalty-based-financing-entrepreneurs/.)) Secondly, unlike some equity financing deals, royalty financing arrangements are not subject to state and federal securities laws. ((Royalty Financing, Inc., http://www.inc.com/encyclopedia/royalty-financing.html, (last visited Nov. 29, 2013).)) Consequently, the investee is able to save the time and money it might otherwise devote to complex filings and legal fees. This enables investees to focus more on business decisions rather than exit strategies. Thirdly, royalty financing has more flexible payment schedules and can mitigate investees’ financial leverage risk. ((Venture Hype, Royalty Based Investment Works Best on These Companies, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-works-companies/.)) Such features are especially beneficial for investees that have seasonal fluctuations. ((Kristina Michelson, Revenue-Based Financing, University of Vermont: Extension Guide to Supporting the Community Supported Farm, http://www.uvm.edu/~susagctr/resources/FinGuideChapter7.pdf, (last visited Nov. 28, 2013).)) Fourthly, payments exceeding original principal are deductible expenses for investees. ((Venture Hype, Royalty Based Investment Works Best on These Companies, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-works-companies/.)) Lastly, royalty revenues do not show up on the balance sheet as debt, making the investees more attractable to potential investors. ((Rosemary Peavler, Royalty Financing – An Equity Investment in Future Sales, http://bizfinance.about.com/od/equityfinancing/qt/Royalty_Financing.htm, (last visited Nov. 27, 2013).))
Disadvantages for Investors and Investees
Firstly, regardless of how successful the investment turns out to be, capped returns limit the investors’ financial gains. ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.)) Secondly, royalty financing may have ultimately slow paybacks. ((Id.)) Investors will usually start receiving paybacks after the investee’s revenues exceed a certain threshold. Therefore, if the investee does not achieve the certain revenue threshold for a long time, the investors will not be able to start obtaining returns on their investments. In addition, since royalties are usually set at a fixed percentage of the investee’s revenue, it may take longer for investors to recover their investments and obtain returns compared to public offerings or acquisitions. Thirdly, investors do not have control over the investee and may have limited options to challenge management decisions. Fourthly, in comparison to stock markets, as a market for royalty financing does not exist, once an investment is made, investors have very limited or no options for liquidity.
For investees, on the other hand, one disadvantage is that they would not be able to invest all of their revenues on future growth but would have to use what is left after royalty payments. ((Id.)) Since start-ups are typically in debt or investing heavily in capital improvements during the initial stage, revenue-based payments could detract from the investees’ ability to pay down principal on loans or make investments in infrastructure in a timely manner. However, this can be avoided if both parties reach an agreement for providing royalties upon achievement of certain pre-determined milestones. ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.)) Secondly, royalty based investors are usually not committed to future growth and do not commit additional or follow-on funds to investees. ((Id.)) Thirdly, since royalties are usually based on a percentage of revenues, investees have to make royalty payments even if it is not profitable, thus diminishing operating capital. ((Id.)) However, the investee can factor the negotiated variable cost into its revenue model to insure that the agreed upon monthly percentage of gross revenue payment to the note holder is at a rate that provides for sufficient operating capital. ((Id.)) Fourthly, since Royalty financing is a loan, if the investee defaults on repayments, it can be forced to liquidate its assets in order to repay the returns. ((Id.))
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