Chapter 8 - Royalty Financing

Question 1

what is royalty financing? what is this also referred to?

Answer 1

royalty financing is also called revenue-based financing - and is a type of funding in which a companty agrees to share a percentage of future revenue with an investor in exchange for capital up-front

Question 2

what is the 5 types of revenues that royalty financing is suitable for?

Answer 2

1 - industries without many hard assets (ie. saas business)
2 - small business that have elasticity in pricing, so they can raise prices to cover a % of royalties without losing customers
3 - compared to traditional debt financing, royalty financing provides more convenient payback terms and less penalties for default
4 - institutional investors may prefer royalty financing because it can serve as a bridge or interim to get to next financing round
5 - appropriate for companies that are looking for more funding but want to prevent a lower valuation

Question 3

what are two examples of companies that would not want royalty financing? (2)

Answer 3

1 - companies with tight profit margins

2 - companies with unproven revenues

Question 4

what are the three main characteristics of companies that are suitable for royalty financing (3)

Answer 4

1 - profitable
2 - possess high growth margins above 40%
3 - be forecasting growth

Question 5

what are the four fundamental items of agreement as it relates to royalty financing? (4)

Answer 5

1 - principal amount of investment and overall multiple to be returned
2 - time frame for returning the original principal investment (18-48 months)
3 - time frame for providing the remaining investment return (4-6 years)
4 - maximum contractual time to provide the total investment return (8+ years)

Question 6

similar to traditional loans, revenue-based financing requires an agreement that includes these 6 legal terms

Answer 6

1 - financing amount 
2 - repayment terms
3 - maturity date 
4 - event of default 
5 - default remedies
6 - reps and warranties

Question 7

what are the 6 main advantages of royalty financing

Answer 7

1 - non-dilutive capital
2 - does not affect debt structure
3 - priorities are aligned
4 - royalty financing is usually faster than debt/equity financing
5 - capital usually comes unrestricted for a % of revenues
6 - more flexible than debt in terms of default penalties - royalty financing ebbs and flows with revenue base - less or no covenants

Question 8

what are the 8 disadvantages of royalty financing?

Answer 8

1 - can be expensive
2 - reduces margins and profitability
3 - financier enjoys revenue upside but not downside risk
4 - royalty based investors are not committed to future growth and do not commit additional or follow-on funds to investees
5 - may detract from company’s ability to service existing debt or make investments in a timely manner
6 - royalties are usually based on revenues, and investees have to make royalty payments even if it is not profitable to operating capital
7 - financing is better suited for business with high gross margins
8 - royalty financing does not provide any added value of private equity or venture capital as royalty financiers do not tend to specialize in improving businesses significantly

Question 9

how can royalty financing be exited?

Answer 9

royalty financing can often be exited by an agreed-upon triggering event, whereby a lump-sum is paid to the financier in order to terminate the royalty agreement