Sophisticated angel investors strongly favor equity over debt. We already know that.
* This is Part 2 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.
These angels are predominantly equity investors who live by the exit-dependent investment models. No exits, no returns.
Having barely survived the depressing exit environment in the past years, some investors are experimenting with a new investment model that doesn’t depend on exits and that would help them achieve some returns even in a tough exit climate.
The approach, called royalty based investment (or “royalty based financing“), isn’t new. It’s been successfully used in “mining, intellectual property, film, theater, music and other industries,” Rock Water Capital, an investment fund specialized in royalty-based investment, comments on its website. But the concept has only been applied to earlier (not startup) stage technology companies by a handful of people.
The idea is simple. Instead of buying equity, you buy a percentage of the company’s future revenues.
So, rather than having to rely on an exit, which could take years to (or might never) occur, you receive royalties (typically between 1 and 10 percent of the company’s revenues) from the company every month until a negotiated multiple (e.g. 3x to 5x) of your original investment has been returned to you.
That is, you can recoup some of your investment almost immediately.
Eager to test out the model, Andy Sack of TechStars and Founder’s Co-op recently raised US $6 million from Voyager Capital, Summit Capital, and Founder’s Co-op, and founded RevenueLoan to specifically make investments using the royalty-based model.
Here’s a hypothetical example from RBF Central:
Tom is the CEO of a promising Software as a Service (SaaS) business. He’s built the business with no outside capital and is operating close to breakeven. He sees an opportunity to ramp up sales by investing in business development. He doesn’t have enough cash in the bank to make this happen.
Most banks won’t lend to a company like Tom’s because his isn’t an asset-intensive business. Tom doesn’t want to raise venture capital because he doesn’t want the dilution and he isn’t sure his business has the potential to scale as quickly or or as big as most VCs would expect.
Tom learns about Royalty Based Financing. He lines up a group of angel investors willing to invest $500,000 for a royalty rate of 10% of gross revenues. The royalty payments don’t begin for a year – giving him time to invest and build the business – and have a 3x cap (limiting Tom’s total royalty payout to a maximum of $1.5 million).
With the help of this additional capital, Tom builds a profitable small business with revenues of $3 million a year — and still owns 100% of the equity. The investors get their 3x return paid back over 5 years — without having to force Tom to sell his company or buy their shares. In this scenario, everyone wins.
The innovation here lies in bringing the Royalty Based Finance approach to riskier, earlier-stage investing, while receiving the expected return in the form of cash flows. The fact is, most well-run businesses look more like the firm in this example – growing, profitable, but not a shoot-the-moon success – than like the Google and Amazon.com rocket rides that the traditional venture industry is geared around.
While supporters swear by the model’s “built-in” exit and non-dilutive feature, those against it simply think it’s a bad idea as it caps investor returns and taps into the cash that should be reinvested in the company.
The royalty based model isn’t for every deal, that’s for sure, but it doesn’t mean that you can’t diversify your portfolio by funding some of the companies with this approach.
Let’s examine the model’s merits and challenges closely and objectively.
In a new series, we’ll break down the benefits and drawbacks of the royalty based approach for investors and entrepreneurs, and the type of companies that are suitable for royalty based investment. You’ll find comments from people who are in favor of as well as against this investment vehicle.
Is the royalty based approach an Advil for tough exit pain? Stay tuned.
* For series, references are published in the last installment of the series.
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