For funding startups, should angel investors consider a royalty based investment model? Why or why not?
7 Answers
Andy Sack,
Views
I absolutely think that royalty and revenue based finance should be considered by angels and funds. Ok -- I'm biased. I'm so convinced that revenue based finance is important that I started a company called RevenueLoan (www.revenueloan.com) in addition to my equity orient Seattle based angel fund (www.founderscoop.com) to pursue this model. Why? Because I think that there are lots of instances and lots of companies where this model is preferable for the entrepreneur than straight equity. Let me explain, revenue based investments have the following benefits when compared to straight equity:
- Generally, revenue based investments are cheaper for the entrepreneur than straight equity. Often, significantly cheaper. If you think about selling equity -- often that's for 20% of the company. One can think of that equity sale as a 20% perpetual royalty.
- Revenue based investments don't involve control provisions. Entrepreneurs who don't want the hassle of dealing with investors on the board of directors are attracted to royalty based finance.
- Revenue based investment align entrepreneur and investor incentives in growing revenues and growing the revenue line and thus, growing the business. This is GOOD! And the right focus. When the entrepreneur and business increase sales, the entrepreneur wins and the investor wins. When growing sales takes longer, the entrepreneur isn't punished. This is GOOD!
- The main objection to revenue based investments in my opinion revolve around the precious commodity of cash and not profit. It's true, revenue based investment require the company to have sufficient margin to pay them off and they take precious cash out of the company. That said, no investment is free and the benefits of revenue based investments far out weigh the costs.
Michael 'Luni' Libes,
Views
For most companies, a revenue-based investment (RBI) makes far more sense than standard equity. Equity only makes sense for the few companies that fit the VC investment thesis: huge market opportunity, high growth plan, little competition or winner-take-all, and a potential for "exit" upon success.
This thesis fits the 2000-3000 seed and early-stage venture investments, and it fits some of the 20,000-30,000 Angel investments, but as we can see from the hundreds of M&As and IPOs per year, it does not in fact fit most of those opportunities.
A very reasonable alternative for both investor and entrepreneur is a revenue-based investment (either in debt form or equity). As Andy Sack says, it aligns both parties with a single goal: grow revenues.
For a startup, finding and then growing revenues should be the sole focus. Having an investor with any other incentive is nothing but distracting. Most often, as early-stage companies begin growing, this is not a problem, but for most, there comes a time when revenue growth is not meeting plan, or when the next round of capital is required, or when some other "fire" grows out of control. At those times, this mismatch of incentives often rears its head and entrepreneurs find themselves fighting in the board room rather than having everyone focus on revenues, as ultimately only revenues keeps any business in business.
Yes, RBI can have issues with cash being siphoned out of a company. But such "expenses" are fixed and known before the financing, and thus can be accounted for.
Yes, RBI lets investors "cash out" before later investors and before the entrepreneurs, but unlike equity, it then leaves the ownership and control of companies in the hands of the entrepreneurs.
Ultimately, what RBI allows for is an investment that fits the 400,000-500,000 businesses started each year that don't need the scale of money available through the venture capitalists. It does so while allowing investors to earn 3x-5x returns, without risking 100% of their capital waiting for an "exit" that 99% of companies do not provide.
For these reasons and more, I not only advocate RBI, but use it as part of the investment thesis and investment structure at Fledge, the "conscious" company incubator (http://fledge.co).
This thesis fits the 2000-3000 seed and early-stage venture investments, and it fits some of the 20,000-30,000 Angel investments, but as we can see from the hundreds of M&As and IPOs per year, it does not in fact fit most of those opportunities.
A very reasonable alternative for both investor and entrepreneur is a revenue-based investment (either in debt form or equity). As Andy Sack says, it aligns both parties with a single goal: grow revenues.
For a startup, finding and then growing revenues should be the sole focus. Having an investor with any other incentive is nothing but distracting. Most often, as early-stage companies begin growing, this is not a problem, but for most, there comes a time when revenue growth is not meeting plan, or when the next round of capital is required, or when some other "fire" grows out of control. At those times, this mismatch of incentives often rears its head and entrepreneurs find themselves fighting in the board room rather than having everyone focus on revenues, as ultimately only revenues keeps any business in business.
Yes, RBI can have issues with cash being siphoned out of a company. But such "expenses" are fixed and known before the financing, and thus can be accounted for.
Yes, RBI lets investors "cash out" before later investors and before the entrepreneurs, but unlike equity, it then leaves the ownership and control of companies in the hands of the entrepreneurs.
Ultimately, what RBI allows for is an investment that fits the 400,000-500,000 businesses started each year that don't need the scale of money available through the venture capitalists. It does so while allowing investors to earn 3x-5x returns, without risking 100% of their capital waiting for an "exit" that 99% of companies do not provide.
For these reasons and more, I not only advocate RBI, but use it as part of the investment thesis and investment structure at Fledge, the "conscious" company incubator (http://fledge.co).
No, no, and more no.
Here are some problems with royalties:
If you want to own a percentage of a company's revenues, easier just to form an LLC and work it out within a membership agreement.
I would distinguish that somewhat from project financing, which is of course the way lots of things are funded, from bridges to Hollywood films.
Here are some problems with royalties:
- If the royalty is based on unit sales of a product or service it distorts the economics by increasing cost and reducing effective gross margin. As a result the company doesn't have the full range of pricing and go-to-market options: if the company owes the investor $1 per download, they're not going to do a $0.50 introductory first month offer.
- If the royalty is a percentage of profits it conflicts with planning for taxes and retaining earnings / capital appreciation.
- It is very hard to craft a royalty agreement that is fair under inevitable circumstances that a company will face as it grows. Royalty agreements often end up in dispute.
- Unless there's a cap, near-term expiration, or fancy formula to dilute the royalty it's going to make the company unattractive to future investors or acquirers. If company A owes investors a 10% royalty and wants to merge with equally-priced company B, does the royalty go down to 5%?
If you want to own a percentage of a company's revenues, easier just to form an LLC and work it out within a membership agreement.
I would distinguish that somewhat from project financing, which is of course the way lots of things are funded, from bridges to Hollywood films.
Andrew Boardman,
Views
For startups that match the VC model (high growth, market land grab, accelerate from funding round to funding round at regular intervals), keeping the ownership structure of the company clean and standard is an important way to both make VC rounds easier and a signal to potential investors that you know what you're doing.
If your startup doesn't match that pattern (and all too many entrepreneurs try to shoehorn them in when they don't), try to find the one it does match. Getting the investors and company aligned (which is what a lot of the existing answers are talking about) is very important. I've no doubt a royalty based model is a good match for many business models.
For a first time entrepreneur, and even most serial entrepreneurs, the funding model is not where you want to do your innovation.
For the investor looking at a startup, if the funding model doesn't match with your understanding of the business model, that's a red flag that requires more investigation.
If your startup doesn't match that pattern (and all too many entrepreneurs try to shoehorn them in when they don't), try to find the one it does match. Getting the investors and company aligned (which is what a lot of the existing answers are talking about) is very important. I've no doubt a royalty based model is a good match for many business models.
For a first time entrepreneur, and even most serial entrepreneurs, the funding model is not where you want to do your innovation.
For the investor looking at a startup, if the funding model doesn't match with your understanding of the business model, that's a red flag that requires more investigation.
Michael North
Views
I've discussed this thread with Arthur Lipper, my colleague in the field of royalty finance. He was moved to compose the following...
"One of the primary reasons to become a business owner is to profit from ownership of the business if it becomes successful, and to have the benefits and perks of ownership.
But once you have sold any of your shares, you are the controlling shareholder, and you have fiduciary responsibilities to the minority shareholders. Your personal financial interests and those of the other shareholders inevitably come into conflict.
For example -- should the company lease a Mercedes or a Honda for the CEO? Should the CEO take his wife to conventions? Does the CEO need artwork in his office? Should the company sell out, merge or acquire a competitor? How much compensation, and in what form, should be paid the CEO? Is it reasonable for the company to pay life insurance premiums for the CEO if he is no longer the sole proprietor of the company? Are short-term profits more important than the strategic positioning of the company, if some of the shareholders want the company to go public?"
These ideas, and an advocacy of royalty finance as a logical alternative to venture capital, are developed further in the following post; did not want to burden this forum with the whole piece: Financing Companies
"One of the primary reasons to become a business owner is to profit from ownership of the business if it becomes successful, and to have the benefits and perks of ownership.
But once you have sold any of your shares, you are the controlling shareholder, and you have fiduciary responsibilities to the minority shareholders. Your personal financial interests and those of the other shareholders inevitably come into conflict.
For example -- should the company lease a Mercedes or a Honda for the CEO? Should the CEO take his wife to conventions? Does the CEO need artwork in his office? Should the company sell out, merge or acquire a competitor? How much compensation, and in what form, should be paid the CEO? Is it reasonable for the company to pay life insurance premiums for the CEO if he is no longer the sole proprietor of the company? Are short-term profits more important than the strategic positioning of the company, if some of the shareholders want the company to go public?"
These ideas, and an advocacy of royalty finance as a logical alternative to venture capital, are developed further in the following post; did not want to burden this forum with the whole piece: Financing Companies
