Royalty Funding – No Dilution, No Exposure

Royalty Funding - No Dilution, No Exposure

Royalty funding is an exciting option for many businesses in different stages of funding. It incentivizes investors to "give you a hand" without giving away your company.

Here is a recap of new writings by Royalty funding expert Arthur Lipper. Arthur is one of the world's most knowledgeable professionals on this method of funding.

Over the past few months, a favorite topic of mine has been neglected and for this, I apologize.  Many of you showed a great deal of interest in royalties as a means of funding.  So I want to keep you fresh on the subject.  So does Arthur Lipper, who continues to write at least one blog post weekly on the subject.

A quick review: royalty funding (also known as revenue royalties and revenue participation) solves several key problems for you and for your investors.  For you (as a business owner):

• No dilution - you keep all of your stock
• No fiduciary duty to the investor -- only a contract
• No exposure to stockholder lawsuits
• No other attempts by the investor to control your business decisions
• Like a loan, disagreements over company valuation do not block the investment
• Unlike a loan, your payments are flexible, proportional to revenues
• The investor does have an incentive to help you grow revenues

For the investor:

• Income begins flowing quickly
• Capital can be repaid within (typically) three to five years
• The upside can be almost as good as owning equity (stock)
• Since the risk of loss of capital is reduced, the IRR across the investor's portfolio is higher

For early stage companies (pre-revenue or revenue potential is not yet proven), you can combine a royalty (revenue participation) contract with a loan.  This kind of debt is sometimes called mezzanine debt with a kicker.  It's subordinate to your cash flow line of credit and A/R financing, but it's senior to equity.  It's in the middle of your capital stack, hence "mezzanine."  Like most issues of mezzanine debt, the interest paid on the loan is supplemented by a "kicker" - supplementary returns paid to the investor - a sweetener which compensates for the risk of your business youth.  This might be a percentage of profits, a percentage of revenues, and/or a percentage of any liquidity event.  If the kicker is a percentage of revenues, then it's called a royalty or a revenue participation.  This is what Arthur Lipper and I recommend.

To keep you informed on this important topic, Arthur has created a new website sponsored by Intelliversity -- Royalties Writings.  If you go there frequently, you'll be kept abreast.  To make this easier, I will from time-to-time recap the articles on the Royalties Writings site.  Here's what's there now:

Let me point you to the first and third above.  "Funding Pre-Revenue Companies Using a REX Designed Royalty" provides a survey of the various methods and tools involved in creating a revenue participation program.  In this post, Arthur recommends "debt+share" as the preferable approach for pre-revenue companies.  This is the same as I've described above as "mezzanine debt with a kicker."

In "Royalty Investor Due Diligence" you'll get a flavor for the kind of questions investors may ask.  Here you can see that the questions revolve primarily around your ability to create and sustain revenue growth, rather than your ability to execute an acquisition or increase stockholder value.

In all fairness, it's very likely investors will ask the same kinds of questions that would be asked in a stock purchase or convertible debt.  This is because the royalty contract may include clauses that reward the investor upon a liquidity event, a kicker on top of the kicker.  Nevertheless, this article on due diligence gives you the flavor of what it's like dealing with a royalty investor -- easier and more cooperative.

Key Takeaway:  Strongly consider offering a mezzanine debt plus royalty kicker in lieu of convertible debt, assuming there are revenues expected within a year or so of investment.  In order to structure the contract and term sheet, contact Arthur Lipper (arthurlipper@gmail.com) or myself (robk@intelliversity.info).