Royalty Based Investment Sucks As a Funding Model (?)

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This is Part 7 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.

You’ve seen 2 exit-dependent investment models used by equity investors and understood why some investors are exploring an investment vehicle, called royalty based investment (or “royalty based financing”), that doesn’t depend on exits.

Fans of the approach rave about its build-in exit and non-dilutive features. Eager to test out the model, Andy Sack of TechStars and Founders Co-op recently founded RevenueLoan to fund companies using solely the royalty based approach.

That caught your attention. You wanted to learn more so you dived right into the debt and equity components that made up the royalty based investment vehicle and gained a solid understanding on its repayment structures and the type of companies that would work best with this model.

You went on to read about its benefits to investors and entrepreneurs. So far, so good, but being a smart person that you are, you know there’s got to be some drawbacks of the model.

What’s the catch? You asked.

You’re right. Not everyone’s a fan. Let’s turn to some common complaints about the royalty based approach.

Drawbacks of Royal Based Investment: Investors

Capped Returns. Investors who are used to swinging for the fences fringe at the capped returns. That is, if the payout is capped at 5x, and if the company you back ends up to be the next Google, 5 times returns is all you’ll get.

“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,” opines Foley & Lardner.

The warrant discussed in Angel Investing: Components of Royalty Based Investment Model only gives you a small equity position – much smaller than that’s received by a traditional equity investor.

Foley & Lardner stresses, “And most investors do assume a significant return when making an investment — they do not enter the investment expecting failure.”

On that point, Jeff Joseph of VenturePopulist asserts, “I would contend that there is nothing smart or sophisticated about excluding 3-5X exit candidates from your opportunity set.”

Slow Payback. If “revenues are from product sales, investors will have to wait 12 to 15 years (or more!) to get any return from early stage companies,” says William Rastetter, partner at VC firm Venrock.

The thing is, no one can know for sure how long it’ll take to receive full returns. It could take a few years or it could take more than 10 – it all depends on the company’s revenue level.

That’s why having a stable, predictable revenue stream is one of the investment criteria for the royalty based approach. Even so, the business environment changes so quickly no one can be sure of anything; otherwise, we’d all be billionaires!

Tax Credits Disqualification. As mentioned throughout the series, royalty based financing is, in essence, a loan that works best for relatively established companies with an annual revenue stream of between US$1 and US$10 million.

This may disqualify angel investors from claiming angel tax credits, not only because you can’t claim tax credits on a loan, but also because some states like Connecticut require angel investors to “put money into businesses with gross revenue of less than $1 million,” according to BusinessWeek.

Drawbacks of Royal Based Financing: Entrepreneurs

Growth Impediment. Instead of reinvesting all of its cash in future growth and R&D, the company has to use some of the cash to make regular royalty payments.

Rastetter insists that royalty based financing is a “Bad idea: If revenues include R&D funding, this taps into capital that should be used for value creation.”

But Joseph suggests that there’s a way to reduce its negative impact on growth. For example, investors can include a provision that provides them with the option of securing the return of their initial investment capital and the accrued dividend if the portfolio company has achieved certain pre-determined milestones.

Non-Committed Capital. Unlike traditional equity investors, royalty based investors typically don’t commit additional/follow-on funds to the company. So the company doesn’t gain a source of committed capital to help the company grow.

“Equity aligns investors and management much better,” Rastetter argues.

Lower Operating Capital. Opponents of the approach stress that royalties are based on a percentage of revenues. The company has to make royalty payments even if it’s not profitable. This ends up eating into operating capital.

Joseph counters that the company can factor “the negotiated variable cost into its revenue model to insure that the agreed upon monthly percentage of gross revenues payment to the note holder is at a rate that provides for sufficient operating capital.”

More Liabilities. Royalty-based financing is a loan at its core. 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 off the top, Gordon Empey of Cooley comments.

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 its assets in order to repay the entire unpaid 3x to 5x returns.

Empey has this to say: “[The royalty based financing model] seems appropriate for the rare high revenue company that doesn’t need much capital but is willing to put the company assets at risk of default and give up 3-5x for it.”

Lower Valuation. Royalties are recorded as debt in the financials, which will lower the company’s valuation should it decides to raise addition money to grow or survive. So if the company doesn’t have the money to make regular royalty payments, it might have no choice but to sell equity at a low valuation.

Next, we’ll conclude the series with some final thoughts on the model.