A closer look at royalty financing

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(by Marco Vangelisti)

In a prior article “A New Funding Structure for Slow Money Projects” I introduced the idea of using royalty financing for Slow Money projects. Such structure presents advantages for both investors and entrepreneurs. Investors get to participate in the success of the enterprise with a self-liquidating investment, therefore greatly reducing their liquidity risk compared to an equity investment. The entrepreneur and original owners of the business retain their equity stake and repayments are better adapted to the actual cash flow of the business than interest payments on a loan. See the article “Comparing Royalty Financing to Debt and Equity Financing” for a more in depth discussion on the points above.

The Northern California chapter made its first investment in the form of royalty financing last year which afforded us an opportunity to learn ways to improve on it. Our first royalty structure for a start-up enterprise relied on its sales projections and had a very simple structure: the business received the capital up-front, promised to repay the capital plus a fixed premium by returning to the investors a fixed percentage of its gross revenues starting in year two until the capital plus the premium was paid off. For illustration purposes, assume a $100,000 initial investment, a premium of $50,000 and a royalty payment of 3% of gross revenues. How long it would take to repay $150,000 out of the 3% of gross revenues very much depends on the growth path of the actual revenues. The faster the revenues grow the sooner the investors will be repaid and therefore the higher their IRR (internal rate of return).

Unlike interest rates on loans, which have to be determined up front, the IRR of royalties cannot be known in advance and often are based on revenue projections that might not materialize, especially in the case of a start-up with a limited history of actual revenues. It would therefore seem advisable to structure the royalty financing in a way that guarantees a minimum return to investors regardless of the accuracy of the revenue projections. Similarly, a prepayment option cold be agreed upon to cap the IRR paid to investors. This can be achieved by setting a finite time period at the end of which any unpaid portion of the initial capital and premium would be due payable. A minimum IRR for investors could then be determined by assuming zero growth in revenues over that period of time.

An example will help clarify what is proposed above.

Suppose the business we are looking at had revenues of $70K in 2011 and projected revenues of $200K in 2012, $600K in 2013 and so on as indicated in the table above. Imagine that at the beginning of 2012 it received $100,000 from a group of investors in the form of a royalty agreement that called for a premium of $50,000 and a repayment based on 3% of gross revenues starting in year 2013.

If the actual revenues followed projected revenues, investors would be fully repaid (initial investment of $100K plus premium of $50K) by 2016 and receive an IRR of 15%.

As those of you familiar with early stage investing and with start-ups know full well, the revenue projections contained in business plans typically range from very optimistic to pathologically delusional. So it would be wise to test the impact on investors’ expected return of falling short of projections by a significant percentage. In the example above if the actual revenues come in at only 50% of projections the situation would look as follows.

Investors would be repaid by 2018 for an IRR of 11%. If revenues come in at 20% of projections it would take 13 years for the investors to be paid back and the IRR would be 6%. Yet, even this last sobering scenario still assumes the business manages to stay alive that long and continue to grow its revenues over the entire period, which is more than can be said of many a start-ups.

The great variability in both the realized return for investors and the length of the period over which royalty repayments are completed also present a tax accounting challenge. Generally accepted accounting principles (or GAAP) require that investors account for the interest portion of each royalty payment they receive. In the example contained in the table above, when investors receive $9,000 in 2013 they would need to report to the IRS what portion of the $9,000 was interest payment versus principal repayment. Alas, as shown in the examples above, they would not know what interest (or IRR) they will get from this investment until the last dollar of the principal and premium is repaid years later.

A way to structure a royalty arrangement that overcomes both the tax accounting issue mentioned above and the open ended time-frame over which payments might occur is one where the unpaid portion of principal and premium are due at the end of a specified period. Let’s assume in the case above that we use a period of 6 years. This would mean that any unpaid portion of the principal and premium would be due in 2018. Notice that this new arrangement would not change the payment pattern contained in the two tables above. The difference between the two arrangements would only show up when actual revenues fall below 50% of projections.  Here is how the situation would look like if actual revenues were only 20% of projections.

The investors would receive a return of 8% or an occasion to renegotiate the terms for continuing funding the enterprise going forward. A minimum IRR for investors can be computed assuming the revenues remain constant at the 2011 level. In this case, the IRR for investors would be 7% and represent the minimum return associated with such financial arrangement provided the business remains a going concern until 2018. The 7% minimum interest could then be used to determine the portion of each repayment to be accounted as interest versus principal for tax reporting.

Clearly, we are at the very beginning of our exploration of this new form of funding Slow Money projects and we will share our learning as we acquire it by using royalty financing in real life situations. We are very grateful to those pioneering enterprises and investors willing to try innovative and alternative ways to fund the transition to a sustainable food economy.