(Editor’s Note: Beth J. Felder is a partner with Foley & Lardner LLP and has extensive experience representing investors and companies in all stages of growth on various financing transactions. She submitted this column to VentureBeat.)
With the market still in flux, raising capital remains a challenge for startups – and finding it can take some innovative thinking. One method that has been turning heads recently is royalty-based financing.
At its simplest, royalty-based financing is lending against your company’s future revenue stream – but in the venture context, it can have a few wrinkles. Instead of purchasing an equity interest in your company, the investor lends you a set amount of funds, just like a regular bank loan. Your repayment options, however, can have a lot more flexibility.
For example, you could make repayments that are calculated solely as a percentage of your 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 and, perhaps, provide for a period of interest-only payments. The total repayment to the investor, however, is capped at a certain amount (e.g., three times the original loan amount).
Let’s put it in real world terms: Suppose a company needs $1 million. An investor could lend the money on a 10-year repayment plan, paying only interest in the first year and equal monthly installments of principal and interest 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, up to the agreed upon cap, and the company will have achieved fairly low-cost financing without giving up any equity in the company.
And if the investor takes a warrant for a small equity position (as is typical for these transactions), it could see some additional reward from a future sale or IPO of the company without additional risk.
It can be a good deal for entrepreneurs. Royalty-based financing, indeed, comes with many benefits. Included among them:
- It eliminates the need for the investor and entrepreneur to agree on the company’s value at the time of the investment. It also eliminates the need for there to be a single liquidity event in three-to-five years.
- The founder of the company doesn’t suffer much dilution. What little there is comes only from the warrant position. Note, however, that there will be some loss of control 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. That’s particularly appealing for lenders who need to show fast returns to their limited partners 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.
Even with these advantages, though, royalty-based financing isn’t for everybody. When considering whether to go this route, here are a few things to keep in mind:
- Many investors don’t want to be capped on the possible upside returns if the company has 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.
- Your company won’t be able to reinvest all of its available cash towards future growth since it constantly has to repay the financing.
- If you’re an early-stage company, with no product in the market, you royalty-based financing may not be an option for you. These days are often 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.
- This is still, at its core, a loan. If you default in repaying it, the investor can foreclose on assets of your company.
- 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. This is not a source of committed capital that will help your company grow.
While royalty-based financing is unlikely to replace venture equity investments, it can provide an alternative source of income for some companies. And these days, any additional option is a good one.