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Here’s How to Raise Capital with Revenue Royalty Certificates

Lets take a look at the magic of  Revenue Participation Financing or Revenue Royalty Agreements as they are more commonly called these days.  With this method you sell (or buy) a share of a company’s revenue rather than a share of the company equity. This method is in contrast to traditional methods of finance such as selling (or buying) stock (equity) or borrowing (or lending) money in the normal way.  This post will help you to determine if your company qualifies for this type of funding and what it might cost. If you’re an investor, today’s blog will help you determine if this form of investing is for you.

Each source seems to have a different name for essential the same method — for example, “revenue royalty financing”, “synthetic royalty financing”, “revenue sharing” and “revenue-based financing”.

What all forms of Revenue Participation Funding (i.e. revenue royalties) share are the following key features:

  1. There is no sale of stock, shares, equity, membership or partnership
  2. The investor is repaid in a series of payments over a period of years
  3. The size of payments to the lender is determined as a percentage of revenue.

In brief, the advantages of any form of Revenue Participation Funding are, for the offering company:

  • Company stock is preserved for later rounds when it is worth more
  • No need for the offering company to give up management control or board seats
  • No need to agree on company valuation (a difficult process that kills most deals)
  • No need to sell the company to pay investors
  • Unlike a loan, payback to investors flexes along with revenue
  • Unlike a loan, the offering company pays back investors as revenues permit
  • Investors have an incentive to “participate” in the promotion of the offering company, which is healthy for both parties
  • Investors are aligned with company goals, instead of pushing for early sale or IPO

For the investor, the advantages are equally strong:

  • Liquidity is almost immediate, as funds begin flowing back to investors in the first or second year
  • Consistently high IRR can be achieved with relatively lower risk and volatility
  • Returns are effectively inflation-proof
  • No conflicts over strategy and timing of company liquidity event
  • Because there are no exits required, due diligence is simpler
  • For the same reason, portfolio management, to reach a desired aggregate IRR over desired time frames and with desired levels of volatility, is simpler
  • It is easier to influence company success since success is defined by revenue rather than profit or exit
  • While the downsides are less, the upside potential can be almost high as buying equity
  • Personal conflicts, such as with management and board members, and difficult governance decisions, are virtually eliminated

Of course the devil is in the details. Every source of funding differs in the details of their requirements and terms.

I’ve now located and interviewed several sources of Revenue Participation Funding available and I know that more are out there.  These are both private-equity funds and high net worth individuals (angels).  Though they share the advantages listed above, some of the details of requirements and terms differ from source to source.  In today’s blog, I’ll outline the criteria and terms of a typical source interested in helping software and technology-enabled service companies.  After that, I’ll extend this to sources that help other categories of business including biotech, medical devices and life sciences generally.

Here is the typical business criteria for low-risk technology-enabled services:

  • Your company has to have revenue
  • Minimum $15K per month revenue, growing
  • Low growth rate is OK (VC-type fast growth is NOT required)
  • One or two years in business
  • Positive (or a clear path to positive) EBITDA (earnings)
  • Financials are professional prepared (cash accounting is preferred)
  • No prior institutional (venture capital) equity or convertible debt financing
  • Prior bank debt, angel, or friends and family financing is acceptable
  • Management has a high level of personal ownership
  • Future liquidity event is NOT required (life style business is OK)

Note, the above are the criteria given to me by one particular investment group. Other individuals and groups will likely have different criteria. You have to shop.

Business criteria for companies not yet receiving revenue

Revenue Participation Funding is also available for companies that are not yet generating revenue. Since this is a more speculative type of investing, but many high net worth investors embrace these opportunities. Investment criteria vary from investor to investor, so the following is a suggestion of what you can expect:

  • The offering company has to project revenue to begin within twelve months
  • Product or service is already in prototype form, or better yet, production-ready form, thus eliminating technology risk, though not necessarily ready for market
  • Product or service solves a clear problem and is easy to understand
  • Total projected revenue is large enough to justify the investment
  • Margins are sufficient to support repayment plan (see below)
  • Low growth rate is OK
  • Management team includes execution talent, more than one person, including a senior member with execution talent and experience in the field
  • Management has a high level of personal skin-in-the-game

In both cases, investors are clear about the way they want the offering company to use the funds. Typical use-of-funds requirements are as follows:

Here is a typical Use of funds:

  • No debt or investor buybacks (with some exceptions on a negotiated basis)
  • Use of funds is for scaling the company, i.e. for sales and marketing, with some allowance for finalizing the product for production and marketing
  • The loan is sufficient to get to profitability (so that additional rounds of funding are not required, though they may be planned to boost growth)

The terms of loans provided by this typical source, allowing for pre-revenue and startup ventures, are as follows:

A typical repayment plan looks like this:

  • The plan is designed so that repayment of principle is complete in about five years
  • Reduced royalties are then paid to investors for a ten to twenty year period
  • Repay is a percentage of monthly cash revenue (2% to 10%, often around 5%)
  • Repayment percentage can decrease at several points in time such as after the principle has been repaid then again after a certain number of years or after a desired IRR (internal rate of return) has been achieved
  • There is a redemption plan included, allowing the investor to earn expected future royalty as a lump sum upon an acquisition or IPO

To keep it simple, there are only four major issues that have to be negotiated between offering company and investor:

  1. The amount of the investment
  2. The percentage of revenues to pay as royalties (which may be reduced in stages)
  3. The number of years in the plan (or in each stage if there are multiple stages)
  4. What intellectual property is held as security and when is it released

These are typical terms, not the only terms.  I have found that there are variations in each of these terms from source to source.  Also, some sources use a boilerplate term sheet that doesn’t vary from deal to deal, while other sources allow negotiation and variation from deal to deal. No matter how the repayment plan is developed, if a rational repayment plan cannot be found given the company’s margins and projected revenues, then Revenue Participation Funding is not possible for that company. Otherwise, it is possible, obviously.

Each investor source differs in the size of funding provided.  One source loans up to $1,000,000 on the basis of Revenue Participation Funding, while another never loans less than that amount and prefers $3,000,000. Another prefers much larger deals in the $10,000,000 range, frequently in combination with equity. It appears that the higher the loan amount, the more the lender allows negotiation and flexibility of terms.

 

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