Should more angel investors consider a royalty based investment model?

I just answered this question on quora -- please vote it up here.

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 in addition to my equity orient Seattle based angel fund Founder's Co-op 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:

1. 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.
2. Revenue based investments don't involve significant control provisions. Entrepreneurs who don't want the hassle of dealing with investors on the board of directors are attracted to royalty based finance.
3. 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!
4. 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.

In short, in my opinion, royalty and revenue based investments are a great tool for angels to have in their tool chest.  

Just my -- albeit biased -- $0.02.

 

Comments

[Ehren Brav]

Agree - it's good that there are several options for investments into an early stage company. That gives everybody more choices. It also allows investments into companies that may take longer to grow/exit than traditional VC would allow.

But the devil is in the details. I don't suppose there is a "prepayment" option for the borrower (even at a penalty)? Would subsequent equity investors view royalty-based financing as an impediment to making their own investment?

Of course, the biggest question is pricing. Your point #1 assumes that the equity of the company substantially appreciates. But if the equity valuation is flat, a revenue-based loan ends up being more expensive than the equity, right (of course, nobody wants this to actually occur)? Finally, a lot depends on where you set the cap on monthly royalty payments.

Also, I wonder whether a company that is already sufficiently cash-flow positive to receive royalty-based financing could just instead qualify for a normal bank loan (which I imagine would be cheaper) based on the strength of its revenues.

But on the incentives and control points, I think it's clearly more entrepreneur-friendly. Maybe the ideal would be a hybrid - a small equity slice so the investor gets a bit of unlimited upside, but enough royalty-based financing to allow investment into a company that might take longer to grow/exit.

Bonus point - I have no idea how this sort of royalty would be taxed...one of the nice things about equity is its tax-favored status. Would that be a factor in pricing?

[Ram Dutt]

I love the idea, I think that this is a new and unique model and if executed well can really harness multiple benefits. You will never know until you try and see how it works out in the long term.