There are essentially three ways to invest in a company: equity, debt (in our case normally convertible to equity!), and a royalty-style vehicle. The latter is a particularly interesting option because it provides for returns starting much earlier, appropriate aggregate returns to be exciting as an investment vehicle (depending on your expectations!), and does not require that the invested venture have an exit strategy or plan, making many, many more businesses investable. We tend to use the royalty style deal for specific types of deals where faster returns are desired or required. Having several of these in your portfolio appears to add balance by delivering returns along the way while waiting on larger, equity-style liquidity events.The royalty sharing vehicle is not a debt. It is not an equity, with the caveat that it can be restructured as one (more on this later). It is not a profit sharing arrangement because it comes off the top line as net revenue (allowing for returns and charge backs). Although, the agreement is structured in the same fashion that a convertible promissory note, it does not function as one. Essentially, the invested company should treat it as an expense. The invested company may choose to treat it as a discount to revenue and deduct it from Cost of Goods Sold or Cost of Sales. Regardless, you should receive a 1099Misc at the end of the year unless it is closed through ACG, where we will divvy that up and you will realize it through your annual K-1.

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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