Contributed by Robert Steven Kramarz of IntelliversityCampus.org
Before explaining Revenue Royalties, it’s important to understand why selling equity in your company might not work.
Most entrepreneurs believe the ideal way to finance their company at an early stage, before bank loans are readily available,
is to sell stock or equity – that is, to sell a percentage of the ownership of the company.
You can still do this in cases of very fast growing companies in some niches such as computer software.
To do this, your investors have to be confident you have a good chance to sell the company (or take it public) within a
relatively short period of time, typically three to five years. In other words, investors have to believe your “exit strategy/”
This gives them a shot at a “home run” – i.e. very large returns on their investment.
Will it work for you and your business?
Quoting Forbes Magazine, July 22, 2013:
According to the Small Business Administration, about 600,000 new businesses are started in the U.S. each year, and the number of startups funded by VCs was about 300. This means that the probability of an average new business getting VC is about 0.0005, and it also means that 99.95% of entrepreneurs will not get VC.
Are your odds better if you are an existing venture? It does not seem to change much. More entrepreneurs may get VC, but the proportion seems to be about the same. Most VCs like to invest in ventures after the potential has been proven. In the first quarter of 2012, only three percent of VC funding went to startups. So about 97% goes to ventures on a post-startup basis, and the number of ventures funded increases to about 3,000-3,500.” ~ Dileep Rao
What about financing by angels (high net-worth individuals)?
These statistics vary widely, so we’ll speak from our direct experience as members of Tech Coast Angels, San Diego chapter.
(Both founders of Intelliversity have been members.)
Over a period of years, we helped review about 30 deals a month or about 600 deals over two years.
Total number of deals funded during that time by the chapter were about 20 – or 3%. 97% had
to find funding elsewhere or never found funding beyond family and friends.
My guess is that no more than 10% of the companies that applied eventually found outside financing from some source,
but it could be as low as 5%. Very few companies get angel financing from people they don’t already know, let alone VC financing.
There is a way out of this quandary for many companies, but before explaining it, it’s useful to answer the question,
was this difficulty in getting outside financing for young companies always true?
We can say from experience that these statistics were somewhat more favorable to entrepreneurs prior to the dot-com bust in 2000.
The change in the economy since then is not just a couple of recessions.
It’s more fundamental than that and more permanent.
The above graph represents our subjective experience, but we’ve verified this through countless discussions with other investors.
The problem is simply that technology is changing more rapidly every year. The rate of change of technology is accelerating.
Think about it. Twenty five+ years ago in 1995 (if you were of thinking age at that time),
you were probably comfortable (right or wrong) imagining the world ten years ahead in say 2005.
- The Internet was a dial-up modem.
- Mobile phones were bricks.
Most of us imagined these tools smaller and faster in 2005, but not fundamentally different.
Fast forward to 2023. Are you comfortable imagining the world in the year 2030?
- Robots everywhere building homes and fixing potholes?
- Cell phones replaced by implants?
We’ll bet you’re not comfortable betting on the world in 2030.Yet, the average number of years it takes to secure
a liquidity event (acquisition or public offering) has increased to nine years now and may continue to increase.
Some companies are purchased quickly for their strategic value (Instagram) but most must prove themselves.
Usually, they’re not purchased for their technology (it’s changing too fast) but for their customer base and their teams.
Most new companies are never acquired; they become lifestyle businesses – fine for the owners, not good for investors.
So the bottom line is, investors can’t predict when a company will be acquired, if ever.
Most important for you, investors now know this.
They know that buying equity in a company is usually a crap-shoot.
Here’s what the author recently wrote in an article for Angel Investor News:
Knowing this, investors are increasingly insecure about every investment and compensate by assembling large
portfolios and follow increasingly rigid standards of selection.
We ignore most businesses presented to us because the odds of an exit seem too long.
Then we demand large shares of ownership, knowing that most will never pay at all.
In the end, your business probably does not receive funding.
You’re dreams lie in tatters.
The answer is to stop selling equity.
Start selling a share of revenue – a share of the future top-line revenues of your company.
Selling your future revenues instead of equity is known as “Revenue Royalties,” “revenue participation,” “revenue sharing,” or “revenue- based finance.”
This structure is now increasingly well accepted in the angel and fund communities.
It works in today’s world because with Revenue Royalties, investors appreciate that:
- Liquidity (i.e. cash coming back) begins almost immediately, and
- Liquidity does not depend on an exit event that may never occur.
It’s all about liquidity.
Through built-in liquidity, Revenue Royalties turn long-term uncertainty into near-term certainty.
This makes a real difference to investors.
I’ve recommended Revenue Royalties to a number of companies in the last few years and more than half
have succeeded in raising all of the capital they needed, and quickly.
This can’t be a coincidence. Investors do sit up and notice.
In conclusion, purchasing equity in all but the most explosive or proven companies seems like a
highly speculative gamble to most smart investors today.
So they avoid it or offer unattractive terms to you, resulting in no funding at all.
Most investors want a way to:
- Reduce the likelihood of losing their investment, AND
- Get the cash flowing back to them swiftly.
The conclusion you may draw from the above article is simple: many investors need and want to invest in Revenue Royalties. Your company can benefit from this movement.
Before we present the details of Revenue Royalties as a way to obtain financing, consider the other reasons why selling equity in your business may be a problem for you now:
More Problems with Selling Equity
Problem #1: Valuation
When they purchase equity, investors have to agree with you on what the company might be worth if sold at some future date, and what the chances are of being sold at that price. This is one key element that determines the current value of the company. Figuring this out is a process called “valuation.” The problem is that this agonizing process can take four to six months even after you have located interested investors, and quite often you will never agree on the valuation. While they haggle, you and your team starve.
More times than you can imagine I’ve seen entrepreneurs who believe their company is worth about $10,000,000 right now, just after launch, while investors believe the company is worth only $2,000,000 or less. It takes a long time, if ever, to bridge the difference. Why the huge difference? See Problem #2.
Problem #2: Percentage of Ownership
Ownership percentage has two main meanings to investors:
1) it gives investors some control over major company decisions, such as when to sell the company or take in other investments; and
2) it can give investors a big win on sale of the company, to compensate for the many deals that never perform as expected, and companies that never get sold.
For these reasons, they want a significant share of ownership, usually above 20% and often 40% or more, and usually a seat on the Board of Directors as well. Do you want to give away that much now?
For the above reasons, investors typically know in advance what percentage of a company they want to own.
This affects the valuation. If an investor wants to own only 10% of your company for $1,000,000,
they will tell you the company valuation is $9,000,000 before the investment (the “pre-money” valuation.)
However, if an investor wants to own 25% for their $1,000,000, then the pre-money valuation is only $3,000,000.
This is why pre-money valuations can be much lower than what you think they should be.
There is a natural disagreement about the percentage of your company investors should get: If they get more, you get less.
If you have less, you have less to sell to future investors if you ever need them.
You have less to share with key team members, and, most important, when you eventually sell the company,
there is less of a reward to you at the end of the hard-fought game.
It’s natural to want to hold onto as much equity as possible, or even all your equity, until later.
So you may resist the unattractive deals offered to you, and this will delay or prevent receiving the funds you need.
The way around this disagreement is to offer alternative forms of investment that don’t involve selling equity at all,
at least until the company is further along in growth. Selling Revenue Royalties is an attractive alternative.
Selling Revenue Royalties allows you to retain company stock until such time as you can attract investment without
giving up a large percentage of equity – i.e. until such time as the company’s perceived valuation is much higher.
Revenue Royalties as a Solution
A Faster Path to Funding
Offering Revenue Royalties attracts investors to companies, projects as well as non-profits that can’t sell equity,
or can’t sell it at a price acceptable to you.
Even if you can sell equity, Revenue Royalties eliminates the conflict in the valuation process.
Even if you can sell stock, it’s faster and easier to find interested investors.
They get repaid quickly and with reduced risk of losing their principal.
You get the money needed to survive and grow – win-win.
Here then are the main reasons why investors often prefer Revenue Royalties over purchasing equity:
1: “Built-in liquidity” – Investors Start Receiving Payments Right Away
Payments usually begin in the first few months or the first year or two, depending on agreement and when revenues begin to flow.
We call this “built-in liquidity.”
2: Investors Experience Less Fear of Loss
There’s a lower probability that the principal investment will be lost because the investor does not have to wait
for sale of company or public offering, which may never occur or which may take a decade or more.
When investing in Revenue Royalties, the investor typically receives back the principal
in a relatively short period of time, often three to five years.
That is a shorter time in which the investor’s capital is exposed to loss,
and his exposure decreases each time he receives a royalty payment.
3: Investors Need Only Believe Your Revenue Projections
Investors need only believe your potential to generate revenues (or contributions and grants for non-profits.)
They don’t have to believe that you can sell your company or go public.
They don’t have to believe your exit strategy. You don’t even need an exit strategy.
Investors don’t even have to believe you can make profits any time soon, though they do have to believe
that you can sustain a revenue-generating operation; significant margins are needed to pay the royalties along with all your other expenses.
A Caution About Profit Margins
They need to be significant, in order for revenue royalties to work well.
Paying a 5% royalty on gross revenues will cut directly into your operating margin, so a sound practice is to be certain
that the investment you receive will more than recover the profit margin you sacrifice.
A company with very narrow operating margins that cannot easily be expanded should
probably not consider revenue royalties as a method of financing.
4: If you do sell your company, investors get a home-run anyway
Every Revenue Royalty agreement should contain a home-run clause, often called a “redemption” clause.
This allows owners to sell the company with compelling returns both to founders and royalty investors.
More on this later.
Revenue Royalties Are a Proven Investment Vehicle
Wall Street legend Arthur Lipper has been advocating this solution since the 1980’s for innovative businesses.
You can find it described in Mr. Lipper’s landmark book, Financing and Investing in Private Companies (Probus Publishing, 1988.)
In 2010, he received a U.S. patent on key methods of implementing this method, now called Revenue Royalties
(or Revenue Royalty financing) as a powerful investment vehicle.