Revenue Participation Funding: It’s Here Now
Today, I want to bring you up to date on a favorite topic: Revenue Participation Funding — the idea of selling (or buying) a share of a company’s revenue rather than a share of the company ownership. 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. Today’s blog will help you determine if your company qualifies for this type of funding and what it cost. If you’re an investor, today’s blog will help you determine if this form of investing is for you.
It’s true I thought of this idea (Revenue Participation Funding) four years ago after becoming disillusioned, as an investor myself, in the standard methods of financing growing companies. What I didn’t realize is that other investors had developing similar ideas in various places before I had, such as Arthur Lipper III. They have advanced the “art” of Revenue Participation Funding independent of my work. Now, like mushrooms, this method of finance is popping up all over the place. And it’s available now to growing companies. You can take advantage of this innovation now.
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”. When Arthur Lipper III began recommending this method in the 1980’s he also called it Revenue Participation, though now he prefers “Revenue Royalties.” A rose by any name will smell as sweet.
- There is no sale of stock, shares, equity, membership or partnership
- The investor is repaid in a series of payments over a period of years
- The size of payments to the lender is determined as a percentage of revenue.
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
- Investors have an incentive to “participate” in the promotion of the 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
- 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.
Example of 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 professionally 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 (lifestyle 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:
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:
Typical repayment plan
– 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
– Repayment 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 principal 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:
- The amount of the investment
- The percentage of revenues to pay as royalties (which may be reduced in stages)
- The number of years in the plan (or in each stage if there are multiple stages)
- 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.
There is much more to say on all of these topics, which will be discussed in future blog posts.
Key takeaway: Royalty Participating Funding is an excellent vehicle for companies already producing revenue and for those that are not, that need flexibility in repaying investors. Companies get the funds they need without giving up a high percentage of their ownership or management positions.