Royalty Based Financing - Don’t Give Up Your Equity!

Royalty based financing is an innovative way to raise capital for your business. The model for royalty based financing is not new, and has been in use for countless decades in oil and gas reserves and other stream of income trusts. The interesting part about royalty based financing or “RBF” is that you can get the money you need while decreasing the amount of equity you have to give up. In exchange for less equity, the investor receives a regular dividend that is equal to some percentage of the gross revenues of the business. In the article below you will learn about this method of finance, and whether or not it is applicable to your business.

 

First, of course, the legal disclaimer

 

Please note that the information in this article is not to be used as consulting, accounting, or legal advice. The following information is provided with the understanding that this article is not a substitute for professional advice, and is merely for informational purposes. TheFinanceResource.com  is not responsible for the use of any information contained below or for the factual accuracy of any statements made below.

 

The Article

 

As state above, royalty based financing is a sort of hybrid that combines debt and equity into security. It should be noted that the best candidates for RBF capital are businesses that have very high margins and moderate overhead. As you will be required to provide a sizable dividend, companies that have low margins cannot afford to payout large percentages of gross revenues. Companies that offer services, technology businesses, software firms, and specialty service companies are prime for royalty based financing as they will be able to afford the debt portion of the note.

RBF, in most circumstances, is subordinated debt, which means that other loans will take precedence over this note in the event that the business fails and assets are liquidated. The advantage for an investor is that they can quickly recoup their initial investment if the business does very well and receive large capital appreciation on his or her equity participation.

 

In order to understand RBF, lets take a look at an example. These assumptions are unlikely, but the key to this example is to understand the flow of capital.  X has a patent on a new piece of technology that will revolutionize the industry, so we will assume that the Company will sell for 20 times net earnings. Let’s also assume that Investor B financed the company will a royalty based financing note, and that he contributed $250,000 to the business.

 

In exchange for the investment, the Company agrees to pay the investor 20% of equity plus 10% of all revenues generated by the business for the first five years of operation.

 

First, lets see how much money X Company made during its first five years of operations.

 

Company X

 

Extremely Consolidated Financial Statement

 

	2007	2008	2010	2010	2011
Yearly Revenues	$200,000	$1,000,000	$5,000,000	$7,500,000	$10,000,000
Yearly Profits	$60,000	$300,000	$1,500,000	$2,250,000	$3,000,000
P/E Multiple	20	20	20	20	20
Business Value	$1,200,000	$6,000,000	$30,000,000	$45,000,000	$60,000,000

You can see that based on the yearly profits, the business steadily increases to have a value of $60 million dollars by the first year of operation. Please note that the price to earnings multiple for the Company has not changed, and is only kept constant for simplicity sake. Actual valuations of technology companies (or any company for that matter) are extremely complex.

 

So, the investor receives what? We assumed that the investor would receive 10% of all revenues for the first five years plus 20% of the capital appreciation.

 

Structured Finance
% Revenue	Payout	Equity Stake	Equity Value	Total Payout	ROI
10%	$2,370,000	20%	$12,000,000	$14,370,000	5648.00%

The investor receives 10% of all revenues, which totals $2.37 million dollars of payments during the five year period. The investor also receives stock (equity) that is worth $12 million dollars. The investor’s total return is $14.37 million dollars.

 

Here is another chart depicting other potential payouts.

Structured Finance
% Revenue	Payout	Equity Stake	Equity Value	Total Payout	ROI
10%	$2,370,000	20%	$12,000,000	$14,370,000	5648.00%
11%	$2,607,000	18%	$10,800,000	$13,407,000	5262.80%
12%	$2,844,000	16%	$9,600,000	$12,444,000	4877.60%
13%	$3,081,000	14%	$8,400,000	$11,481,000	4492.40%
14%	$3,318,000	12%	$7,200,000	$10,518,000	4107.20%
15%	$3,555,000	10%	$6,000,000	$9,555,000	3722.00%

 

 

 

 

 

 

 

 

Lets recap the following example, and then we will discuss real world scenarios of how these specialty finance notes actually work.

 

The Assumptions

• We assumed that the valuation of the business would remain a 20 times net earnings. This is not how valuations work, and this was only done for simplicity sake. As a business grows larger, its P/E multiple usually increases significantly from when it was a small business.
• The percentages used for the revenue payouts and equity payouts are very different in the real world, and they may be much higher or lower depending on the strength and potential return of the investment.
• This business had an extremely high growth rate. This rate of growth is very uncommon for most businesses.

In the real world, RBF do not work exactly like this. Most structured finance notes have sliding scales of royalty payments and specific payback periods. Some notes also contain a cap on the amount of money that an investor can make from a note. Each of these deals is complex, and they are mainly used for very large financings that are arranged by third party provides (like investment banks).

In conclusion, royalty based financing is an excellent way to preserve your equity while still getting the financing you need. As stated earlier, this financing is mainly available to service or technology businesses that generate streams of high margin revenue. There are many resources available that expand on these financing concepts. Currently, there are a number of limited partnership type hedge funds that have begun to explore royalty based financing as an alternative to straight equity financing.