ROYALTY FINANCING CAN STRETCH YOUR EQUITY

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The stock market is up over 30,000 points and investing activity continues to soar, yet the search for capital is still challenging.  Entrepreneurs and companies raising capital are always optimistic at the onset but become frustrated with the time it takes and are disappointed with the terms offered if they are fortunate to receive a term sheet.  They read of a financing similar to their own company that closed, and their hopes are buoyed, but often these announcements mask the underlying terms, which may have not been very much new capital but included the conversion of debt or SAFE notes into equity and the round was uncomfortably dilutive.  Yet the publicity surrounding these financings reinforces the notion that that surely money can be found.  This led to the creation of a new security tied to revenue which is based partly on a royalty on sales.  It possesses a number of features that make it highly flexible including its elimination when sales reach a particular threshold.

Most early-stage investors are now using convertible preferred stock or SAFE notes.  These work well with smaller financings of less than $1 million for which there are a host of small funds that have proliferated in the last 10 years.  But then what does a company do when they need to raise a late-seed round or Series A round of $1-4 million . . . that is too large for early-stage seed funds, and too small for most venture capital funds that prefer to invest north of $5 million.

Therein lies problem 1: Financial investors, i.e., Funds, have raised their minimum investment size which can result in excessive dilution for a company that only wants to close on $1-5 million.  These funds that formerly might have made an investment of $1-2 million have since raised larger funds which requires them to increase their minimum investment so they can deploy the capital rapidly.

Therein lies problem 2: Strategic investors are an excellent funding source, but take too long to evaluate, negotiate, and finally approve financings because of their bureaucratic structure and the need to ‘get everybody at each level on board.’  They also are reluctant to make follow-on investments, preferring to let financial investors pick up the slack.

Now comes problem 3. Financial investors, i.e., funds, have become focused on a narrower set of vertical markets that they will invest in, favoring those such as healthcare, eCommerce, and software.  To deviate from their stated area of focus risks losing the support of their limited partners who have warned fund managers to not deviate from their stated investing strategy.  Many financial investors use to be more opportunistic, investing in great opportunities rather than limiting their investing to a narrow vertical.  

In short, we have a capital shortage on our hands for companies seeking $1-5 million.  

Royalty-like Financing: A Non-dilutive, Tax Deductible Financing Alternative

So, let’s take an ‘out-of-the-box’ idea that has actually been around for some years and was revived by a Boston-based innovator, Arthur Fox, in the 1990’s, royalty financing.  More recently royalty financing has been applied by a New Hampshire based quasi-state/private fund, Vested For Growth.  Fox and Vested for Growth were focused on making small loans of under $1 million.  Then a little over a Decade ago, Entrex, Inc. began promulgating the use of a royalty-like security known as a TIGRcub™.  Other funds have focused on drug development and resource (oil and minerals) and structured royalty deals, but most of these firms are limited in the breadth of the types of companies they are willing to invest in.  

A New York boutique investment-banking firm, Griffith Securities, began structuring royalty-like securities for small publicly traded companies about 15 years ago, calling them Revenue Linked Securities.  A Seattle-based firm called RevenueLoan was formed with a focus on financings up to $500,000 for companies with sales of $1-10 million.  Then a Boston-based fund, co-founded by the author, Arctaris Income Fund, provided more than a dozen royalty-type subordinated debt financings over the following 6 years.  Each recipient had revenue of $5 million or more and were profitable.  Then in 2020 the author co-founded Brightside Venture Capital Investors to provide funding of $1 to $5 million to early and mid-stage companies. 

Advantages of a Royalty Type of Financing

First, a royalty type financing is not an investment, but is a form of debt, typically secured with a collateral position that may be subordinated to that of a senior lender.  It may be convertible into equity and it might carry warrants as most subordinated debt loans do.  But as a debt security, it provides a greater degree of comfort to the Fund’s investors.

Companies are attracted to royalty securities because the structure has a number of desirable features, chiefly, the fact that it results in less dilution of the ownership of its shareholders.  This offers a great advantage under most market conditions, especially in an environment where valuations offered by financial investors are below that sought by the principals.  It buys the Company time to grow and justify the valuation it is seeking.  By postponing an equity round through the use of a debt security, a company can avoid sequential equity financings until the valuation ‘catches up’ with the expectations of the founders.

The use of a royalty-like securities does not require that a valuation be agreed upon as is necessary with equity structures, or sub-debt financings where warrants are used to enhance the return. A royalty-like security aligns the interests of  management and a lender, as they both want the company to grow revenue as opposed to focusing on cost reduction to achieve profitability.  Further, the lender’s interests are aligned with earlier investors as everyone is trying to grow the top-line and reduce the dilution of existing shareholders through subsequent financings.

Brightside Venture Capital has added a convertibility feature of their debt instrument that allows the Company to grow its valuation to a subsequent round at which time the debt may convert, and the royalty is ended.  

A royalty type of financing may enable a company to raise capital without experiencing a dilutive ‘down round’ equity financing.  Thus, a company can defer an equity financing until valuations have risen or until the company’s performance justifies the desired valuation.

There are no free rides, however.  Lenders using royalty securities expect to be repaid over a 5-to-10-year period instead of 3-5 years with most sub-debt, or 1-3 years with venture debt.  The royalty portion of the repayment occurs as a percentage of revenue, which can fluctuate as the company’s fortunes wax and wane, which provides the company with some cashflow relief during poorer years.  

The overall cost of royalty-like financing lies somewhere between sub-debt, which is in the high teens, and equity financing, which historically has been structured to yield a return to investors of 40% or higher.  The cost of funding depends heavily on a borrower’s revenue, profitability, and projected growth rate, all of which equates to risk.

Pure Royalty Versus Debt Plus Royalty Structure

There are two types of royalty structures: Pure Royalties in which the return is entirely dependent on a royalty on sales.  These are riskier from the investment perspective as the total return is dependent on the royalty, and therefore the % royalty has to be high.  If the Company does not grow as forecasted, and few do given most company’s optimism, then the investor stands to suffer a low return on their investment.  

The second type is the Debt Plus Royalty in which there are two instruments:  a note which is repaid in 5 years and may or may not be amortizing, and a second instrument that is royalty based, i.e., a Revenue Linked Security.  The debt portion carries interest which is paid monthly.  For companies that are profitable, the note can be structured to amortize the debt over the life of the instrument, which is typically 5 years, and thus incur a lower cost of capital.  

When a company’s sales are low, royalty payments are low and increases as the company’s sales grow and it is able to pay it more easily.  If sales decline for a year or longer for when there is a recession or an event such as Covid-19, the royalty declines as well.  However, these types of financings are structured to yield a targeted return on investment over the life of the loan so if projected revenue is lower in the earlier years, there may be a catchup payment due at the time of a liquidity event.  

All of this is modeled so that given a forecast of projected sales, all of the payments can be seen so that a firm can project its cash flow requirements during the anticipated life of the financing.  If there is a conversion of the debt into equity, triggered by a subsequent financing, this too is modeled because the royalty then ends.  Sound complicated?  Yes, it is but Brightside Venture Capital uses it’s model to explain the financing and openly shares the model with a prospective borrower.  This transparency is a desirable where trust and confidence between funding source and a company forms the basis of a subsequent relationship.

The Cost of Capital

As with all financings, the cost of capital or target IRR sought by the capital provider depends on many factors: the stage of the company, the maturity and experience of management and the completeness of the management team, the completeness of the product, size of market, stability of the technology, volatility or concentration of sales, competitive risk, patents or knowhow, the number of satisfied customers, the sales pipeline and outlook for prospects, the history as well as forecast for profit and loss, the urgency of the company’s funding need, the state of the capital market as well as the national economy, and so forth.  All are taken into account regardless of the type of royalty.  

Once the capital provider has determined what cost of capital or target IRR is appropriate for a particular company, the variables determing the % royalty to be paid is the size of the financing and the number of years over which the payments will be paid.  Where there may be a shortfall in reaching the investor’s target IRR, as may be the case of earlier stage companies and particularly where there is no amortization of the debt, the investor may seek warrants exercisable into equity and/or the option to convert the debt portion into equity.  

The entire exercise is highly formulaic and exhibits none of the black magic which often surrounds the valuation of a company that a traditional equity investment is characterized by.  

Later Stage Financings & Bridge Financings

Management that has already completed an equity round or two may like a royalty financing because it can provide bridge or interim financing to get the company to the next funding round when the valuation may be higher and less dilutive.  Take for instance a company that needs only $1 million of financing now, an amount too small to attract a new equity investor that might propose a down round at a  lower valuation.  Or a situation where the current venture investor may be approaching the upper limit of what their fund can invest in the company.  Under these circumstances a royalty financing may be compatible with the company’s existing capital structure since, with a royalty type of security there are often no conflicts of governance (usually no board seat requirement), and less or possibly no dilution of existing shareholders.

Royalty Financing as a Means of Liquifying Early Investors 

Unlike equity securities, or securities with an equity component such as traditional mezzanine-debt, royalty-like securities may not require a liquidity event for lenders to receive their return on their investment.  Instead, a return is derived from payment of an agreed upon percent of revenues that, over a defined period of 3, 5 or perhaps 10 years that yields the target return on funding that is agreed upon between the investor being bought out and the company.  So, the security could be used to redeem the investment made by early investors anxious to seek liquidity but not force the Company into a premature liquidity event.

Tax Advantage of Royalty-type Financing

Royalty-like financing enjoys another feature:  the amount paid to the lender above the repayment of the original loan is fully tax deductible [1].  In essence the Federal Government is paying a portion of the cost of the financing.

Finally, the financing proceeds show as cash on the asset side of the balance sheet, but the loan may not have a corresponding liability as with senior or subordinated debt, as the repayment of the principal amount is contingent upon revenue being generated.  The net effect is to increase the net worth of the company.  Under FASB, this will probably have to be footnoted in the company’s financial statements as a Contingent Liability [2].

When the Royalty Becomes Too Costly (i.e., the Company grows much faster)

A concern expressed by some company issuers is that the sales forecast upon which a royalty-like payment is structured might yield an excessively high IRR for the lender and a higher than anticipated cost if the company exceeds the forecast upon which the financing was structured.   Our experience is that few companies achieve the forecast they prepare as part of their financing plan and are more likely to end up nearer our adjusted sales forecast.  However, there is the possibility that the company does better than forecasted and revenue soars in which case the royalty becomes too costly.  The simple answer is to prepay the security which a lender provides the option of, which a company could achieve through a refinancing at which time the royalty obligation ends. 

However, the lender might agree to cap the return to assuage fears of an excessive cost of capital or to include a provision in which the royalty security extinguishes before the maturity date as soon as an agreed upon multiple of the original loan has been returned to the lender.  In return the company might be asked to agree to a floor IRR to be paid to the lender and may seek certain guarantees.  Each lender has their preferred terms and may not consider any of these variations.  There is lots of flexibility in how royalty securities can be structured to achieve the objectives of the company while meeting the risk-reward expectations of today’s capital providers.

Candidates for Royalty Types of Financing and Modeling the Alternatives

Early-Stage Companies

Early-stage companies that may not yet be profitable but have some history of revenue and anticipate high growth in years ahead may be candidates for Royalty-type financing.  This is a more difficult exercise than with profitable mid-stage companies and requires a higher target IRR to offset the higher risk.  To keep the royalty rate at an acceptable level the investor may add a provision to convert the obligation into stock, but usually at a valuation that is set by a later equity round.  Also, warrants might be included that are exercisable at some future date into common stock.  Even then, the dilution is generally less than with an equity round.  Structuring a royalty financing for an early-stage company can solve their need especially if they are having difficulty raising venture capital by offering potential investors a lower risk, debt structured alternative.

Mid-Stage Companies

There are some characteristics that a mid-stage company should possess when considering a royalty type of financing.  Ideally the company should:

• Be profitable;
• Possess high gross margins above 40%; and
• Be forecasting significant growth.

Brightside Venture Capital’s model illustrates the effect of the financing on the company’s enterprise value and shows how shareholder value could increase faster with the proposed financing than without it.  The model lends itself to conducting various ‘what-if’s.  Of course, as with any projections, realistic revenue growth forecasts are essential so that the various financing structures can be modeled with reasonable accuracy.

Mid-stage companies that can afford to amortize the loan portion will qualify for a lower cost of capital, i.e., lower interest rate and lower royalty.  Amortization can be structured to require interest payments only during the first 6 or even 12 months.

Family-Owned Companies or ESOP’s

A royalty type of financing could be used by a family-owned company implementing a generational succession plan where the older generation wants to achieve some form of liquidity but is sensitive to ownership dilution or the presence of investors outside the family or immediate ownership group.  Another application of is with employee-owned companies such as ESOP’s, where new equity issuances are complex and often encumbered by highly leveraged balance sheets, and where outside investors other than the employees are generally not welcome.

Small Publicly Held Companies

Last but not least, a royalty type of financing can be used effectively to fund thinly traded or undervalued public companies seeking to raise capital where a secondary offering would not find a receptive market or would have to be priced at market which could be highly dilutive.  A royalty-type financing is not tied to market price.  It could also be used in a tender offer to bring a company private, providing selling shareholders with the liquidity they’ve been waiting for.

Recapitalizing a Company to Provide Liquidity to Investors 

A royalty type of financing can be used in other ways.  For example, to recapitalize a company, in order to enable investors or owners to sell some of their shares back to the company, or simply to provide a company with liquidity to distribute to its shareholders. 

Other Structural Considerations

The royalty associated with a financing can be structured to end in 5 years, 10 years, or longer, however the shorter the maturity, the higher the percent royalty required to amortize the debt and provide the target return.  5-7 years seems to work well as it allows the company to grow without an excessive repayment burden as with venture debt or subordinated debt.  A royalty type security can be redeemed through a prepayment prior to the maturity date, which might be triggered by the acquisition of the company (a change of control) or through a recapitalization that replaces the royalty type security with what then might be a lower cost financing such as conventional subordinated debt.  

If the Company is doing well and is seeking lower cost financing, the provider of the royalty debt might be willing to refinance the security on more favorable terms rather than lose the investment from their portfolio.  They already know the company and you already know them, so it could be highly advantageous not to mention timesaving, to refinance with your current funding source.

The most common event causing an early redemption is when the company is being acquired or raises money through a public offering.  Prepayment is accomplished through a lump sum payment that is calculated using the same internal rate of return (target IRR) that was agreed upon at the inception of the financing.  A small pre-payment penalty may also be applied, which declines as the loan matures.

The cost of capital, that is the IRR sought by the capital provider/investor, should be at a level that will attract capital, yet fit within the capital structure of the company for a financing of this type.  Typically, a royalty type of security is subordinate only to bank debt and is secured by the assets of the business.  We believe that the target IRR should be set somewhere between that which subordinated debt is priced and that which is normally sought for equity, i.e., ranging from the teens for more established companies, and upwards of 30-40% for earlier stage companies.  Larger, more profitable companies would justify lower rates whereas smaller, more volatile and marginally profitable companies with less experience management teams might warrant a higher target IRR, reflecting the level of risk.

When compared to mezzanine financing or convertible preferred financings, royalty type transactions should require less time to close through the use of more standardized documents and should entail lower closing costs.  Once you remove equity from the equation and accept that it is basically a loan, the attorneys will have to work harder to justify recrafting the terms of a deal, which equates to lower fees and closing costs.

In the current economy, royalty types of financing may be the optimal funding solution for a growing number of companies.  The lower dilution benefit and the deferral of an equity round through the use of royalty financing will make it an increasingly attractive option and an appealing investment structure for funds or high net worth investors seeking current cash flow, greater security and an earlier return of capital without relying solely on an acquisition, IPO or other liquidity event.

The author, Andrew Clapp, was co-founder of Arctaris Income Fund, LP which completed more than a dozen Royalty-like investments using a revenue-linked security.  Currently he is Managing Partner of Brightside Venture Capital, which provides funding and funding solutions to early and mid-stage companies using royalty-like revenue linked financing as well as equity funding.  Prior to Arctaris he co-founded Brook Venture Fund I and II, the latter of which was a Small Business Investment Company licensed by the SBA.  He also is a partner with CIG CAP, which provides project financing of $25 million to $2 billion.  He is a speaker on topics that include venture capital and corporate finance.  He may be reached at andy@brightsidevc.com.  

[1] Generally speaking, according to FAS, payments in excess of the principal are eligible for federal income tax deduction as the equivalent of interest expense under certain forms of royalty security structures where the issuer undertakes a non-contingent obligation to repay principal on or by a date certain.  Corporate issuers and lenders should seek specific advice

[2] See FASB 133 and ETIF 88-18, respectively, for general technical guidance on accounting treatment of contingent payment debt obligations and the sale of future revenues.  Issuers and lenders should seek specific advice and counsel from their accountants and attorneys regarding facts and circumstance in order to make a final determination concerning tax and accounting treatment.