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- F&L: Royalty-based lending

In the current economic climate, companies find it hard to finance their growth.
Foley & Lardner, a law firm with an office in Boston flags up royalty-based
financing as an innovative vehicle for raising capital.

At its simplest, royalty-based financing lends against the company’s future
revenue stream. Instead of purchasing an equity interest in a company, the
investor lends the company a set amount of funds, just like a regular loan.
Repayment, however, can be structured in a number of ways in order to suit both
borrower and lender. The borrower could make repayments amounting to a
percentage of the company’s revenue stream over a period of time. Or the loan
could carry a set interest rate in addition to such a revenue component. The
borrower may pay interest only for a period of time (e.g., a year or two) and
then repay the principal and interest on the loan based on a set amortization
schedule, plus a percentage of the company’s revenue stream, over the same
time as the set loan repayment. In any case, the total repayment to the
investor can be capped at a certain amount (such as three times the original
loan amount).

Let’s take an example. Suppose a company needs a $1-million investment. An
investor is willing to lend the money on a 10-year repayment plan with an
interest-only repayment in the first year, principal and interest repaid in
equal monthly installments over the next nine years and, perhaps, payments of
three percent of the company revenues during that same nine-year period. The
investor reaps a return on principal, along with interest and the royalty
amount, while the company achieves fairly low-cost financing without giving up
any equity in the company. This same repayment scenario plays out even if the
loan had no interest component to it, merely involving repayment based on a
percentage of revenues. Here, the same $1-million investment requires a longer
repayment period, and the revenue stream to the investor is more susceptible to
revenue fluctuations. On the other hand, without the interest component, the
repayment carries less risk of default since all payments to the investor are
from the company’s revenues. Under either structure, it appears to be a
win-win for all. And if, as is common, the investor takes a warrant for a small
equity position, the investor could see some additional reward from a future
sale or IPO of the company without taking any additional risk.

This vehicle is starting to gain attention in this difficult economic
environment since it does have a number of benefits.

1. It eliminates the need for agreement on the company’s value at the time
of investment and also the need for a single liquidity event in three-to-five
years. Thus, two of the most prominent bones of contention are removed.

2. The founder of the company suffers only little dilution, viz. that from the
warrant position. The investor will likely want some approval rights on major
actions that could impact the repayment of its investment, since it has no
control through an equity stake.

3. There is a certain return on investment for the investor, helping investors
who need to show returns to their limited partners quickly.

4. Depending on the investor, which could be a private equity fund, the
company could still obtain operational experience and mentoring from the
investor. There are several funds dedicated to making these types of

There are also drawbacks to royalty-based financing:

1. Investors miss out on any upside returns since there is no significant
liquidity event. Nobody would have wanted to invest in Google through
royalty-based financing and not reap the huge financial gains that all of the
other investors realized. The warrant discussed above yields much less than a
traditional equity investor would otherwise receive in a liquidity event. And
most investors do assume a significant return when making an investment -
they do not enter the investment expecting failure.

2. The company itself is not reinvesting all of its available cash towards
future growth, research, and development since it is using some of that cash to
repay the royalty-based financing.

3. Royalty-based financing, particularly with a repayment schedule derived
solely from a percentage of the revenue stream, works best for those companies
that already have a product in the market and the product has a high
gross-profit margin. Early-stage companies without products in the market
generally will not have this vehicle as an available option.

4. Royalty-based financing is still, at its core, a loan. If there is a
default in repayment, the royalty-based financing investor can foreclose on
assets of the company.

5. The company does not gain a source of committed capital from the investor
that will help the company grow. With a venture fund investor, the investor
will typically be available to help the company not only operationally, but
also for the company’s future financing needs.

In the end, the royalty-based financing vehicle is likely a good arrangement for
a small- to mid-size investment amount for a company that already has a product
in the market. While this type of financing arrangement is unlikely to replace
venture equity investments, it can provide an alternative financing source and
structure for some companies.

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