The vehicle is structured to give the invested company a year of grace, where no royalties are due. On the first anniversary, the company begins quarterly payments of X% of net revenue. At the end of each anniversary (beginning with the second), the company must return a minimum of 25% (typically) of the original investment. At the end of five years (typically), an aggregate of 3.5x (typically) must be returned. If the company is underperforming, this looks like a balloon payment. It is also possible to add a warrant package as a kicker in the event the company does hold an exit or you wish to insert yourself on their capitalization table for the purpose of shareholder votes.
If the company defaults, then there are penalties in the form of equity ownership. These penalties are structured such that to default is a very painful process, where the investor may end up owning up to 25% (typically) of the company. But, it also gives you, the investor, great latitude to restructure the deal. Since no shares have been created or distributed, a quick transition is possible and does not require any changes to the cap table. So, it is possible to transition from this revenue sharing contract to an equity deal.
When to use a royalty-style vehicle:
- This is a great vehicle for product based companies where exit multiples are 1.5 to 3x revenue resulting in a much faster ROI and higher IRR.
- This is a great vehicle for services companies where exit multiples are in the range of 1.5x revenue for the same reason, and often making a service-based company investable.
- Growth oriented lifestyle ventures (no desire or plan to exit).
- Companies where their IP or license is expiring that could affect their exit opportunities.
- Companies where management does not expect an exit within 10 years.
What you should know:
- This vehicle provides a lot of leverage in the deal and its ongoing maintenance.
- It is simple to restructure and there are lots of options available.
- There is a tendency for the invested company to try to treat this as an interest expense, which it is not.
- If you overload the royalty rate, you can strangle the company, who will likely want to reinvest all profit into growth.
- Royalty-style deals are easy and cheap to execute.
- They typically provide 3.5x – 5x in aggregate returns and can return 10x or more if the venture outperforms expectations.
- An acquiring company will not want to inherit a revenue sharing obligation. So, there should be a one-time buyout clause in the event of acquisition of the company.
What to do when issuing a royalty-style deal:
- Determine your royalty rate. Typical royalty rates are between 1% and 2% per $100,000 of investment.
- Determine the equity conversion penalties. Penalties should be a sliding scale over the timeline of the agreement to represent the reduction of risk.
- Determine your total return target, typically 3.5x.
- Determine your grace period, typically one year.
- Determine if you will ask for warrants. See revenue sharing calculator attached.
- Determine the one-time buyout solely for the purpose of acquisition, typically 3.5x.
For more information, please see:
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