Most business financing is either debt or equity. A third option is "royalty financing" or “revenue-based financing” where the debtor obtains a loan and pays back the lender with a certain percentage of revenue rather than obtaining a traditional loan to be paid on a set schedule or selling equity interest. Such agreements have traditionally been used in entertainment, mining, oil & gas, and pharmaceutical companies, where a large, consistent stream of revenue is expected quickly. Now this financing structure is being used more frequently by start-ups during the early stages of development.
Royalty financing is ideal for a companies that are in need of capital but are in the late pre-revenue or early revenue stages of development. Often royalty financing is easier to obtain for companies at this stage rather than seek traditional debt financing; banking institutions are more willing to provide debt financing to companies that have established themselves in the market and are at or near profitability. Also, it is a viable option for companies that are not appealing to venture capitalists for equity financing because they are not “poised for rapid growth” or do not have an exit strategy (e.g., by IPO or acquisition). Furthermore, royalty financing does not require the dilution of ownership interests and allows the entrepreneurs to retain complete control.
Typically royalty financing agreements include a promise to provide a loan to be paid back using an agreed upon percentage of gross revenue. Royalty financing agreements contain many of the same terms as traditional loan agreements, including: amount of principal, repayment terms (usually amortized), maturity date, event of default, default remedies, and representations and warranties. This type of payment plan is flexible because the payment structure is not set on rigid monthly or quarterly schedule and can be arranged so as to provide security to investors and protection for the borrower.
Often the repayment plan includes incremental revenue payments at 2 percent to 8 percent of gross revenue over a specified time period or until a specified multiple of the principal is paid back. Additionally, a prudently drafted royalty contract should include provisions regarding acquisition of the firm (often called a success fee), the determination of who is liable for payment if the acquiring firm defaults, control of patents that are developed using royalty financing funds, and contingencies for the loss of a major customer. Default remedies typically mirror those contained in traditional business loans. Also, investors will often request the additional safeguard of stock warrants in case a company grows rapidly into the next Google or Facebook.
- Easier to obtain than loans for some businesses: Often royalty financing is easier to obtain than traditional debt financing from banking institutions where the company is poised to generate a consistent revenue but is still too great a risk to be appealing to typical financial institutions.
- Retained control: Entrepreneurs can obtain capital while retaining control of their organizations and can also refrain from committing to lofty investment-return expectations which are often needed in debt financing.
- Minimized risk of default: The payment schedule is flexible which makes royalty financing especially appealing to businesses whose revenue stream is inconsistent or varies seasonably (although weak revenue may make it more difficult to obtain royalty financing in the first place). Instead of paying a fixed amount per month, the payments will be adjusted for lower revenue in months or quarters with less production or fewer sales. This minimizes the risk of default which also benefits investors who have more security and certainty as a result.
- Tax benefits: Royalty payments can be deducted as a business expense thereby reducing taxable income and often allowing greater after-tax income and more investment in the company’s growth. Secondly, because dividends are paid out of after-tax income, double taxation (taxation of corporate income and then on investor income) on dividends is avoided.
- More focus on business decisions rather than exit strategies and regulation: Royalty financing reduces the pressure to sell the business, which is a consideration that is typically inherent in venture capital investments. Additionally, because royalty financing can be structured to avoid state and federal securities laws, time and money that would normally be spent on complex filings can be allocated more productively.
- Security and faster, liquid returns for investors: Royalty payments provide a return, regardless of whether the venture is profitable. Furthermore, returns can be obtained more quickly depending on the success of the venture and are immediately liquid as opposed to traditional equity financing where the pay-off will often be delayed until an IPO or merger or acquisition of the business.
- Many companies are ill-suited for royalty financing: Companies that have weak growth projections or smaller, inconsistent revenues will have difficulty finding investors willing to use royalty based financing. Companies in the pre-revenue stages will likely be unable to obtain such funding.
- May be more expensive than traditional loans: Start-ups should ensure that a payment ceiling is negotiated carefully for the case in which revenues grow quickly and beyond expectations. If a company has consistent enough income that a bank would approve debt financing it is wise to compare projected costs. The effective interest rate is usually between 18 percent and 30 percent.
- Administration may be more difficult and expensive: Varying monthly payments require frequent determinations of gross revenue to the standards of the financing institution. Investors will often request access to records to ensure they are being paid the appropriate amount.
- Do not use if your company has flat or declining gross margins with scale: Start-ups in small saturated markets or markets in which “low-hanging fruit” is picked early in the business’s life should be cautious. If a company’s marginal gross margin equals the percentage owed in royalties, one should stop selling to achieve the optimal outcome. However, doing so would result in default on the royalty based loan.
- Difficult to liquidate royalty interests: While it may be self-liquidating, there is no consistently active market for royalty interests. So it may be difficult for investors to liquidate royalty interests quickly unlike equity or debt which are more marketable.
- Return on investment is uncertain: The longer it takes for an investee to pay back their loan, the less profit the investor will make. This risk is tied to the growth of the company. This, however, has the effect of aligning the interests of investors and investees which could lead to greater growth due to cooperation.
Entrepreneurs should consult with qualified legal and financial professionals and consider all financing options to determine if royalty financing is right for your business.