Venture Finance - Reality vs. Rumors with Dick Brown
In the search for capital, an investor and an entrepreneur often resemble a cobra meeting a mongoose on a narrow path. Neither side trusts the other. Both fear they will ultimately become locked in a brutalizing fight for survival.
Today’s investors and entrepreneurs have grown wary from prior experiences or industry legends.
Any professional investor can tell you stories of the capital once risked in a new, Silicon Valley venture with a Business Plan and blur-blood references that seemed the very model for a wild, profitable success. But, in “the blink of an eye” the astonished investor discovers all the money is gone … in a frenzy of spending on Porsches, Ferraris and chartered jets to Cabo San Lucas and Paris.
The entrepreneur has been regaled with tales of boardroom jousts where the two protagonists become disenchanted with results and stumble into a brutal struggle for control. Usually the investors who long ago mastered “the golden rule” (“he who has the gold makes the rules”) own the majority of equity in the company. They exercise their power; dump the current management; and replace them with young, inexperienced relatives (or lovers) who proceed to accelerate the venture’s headlong plunge into bankruptcy.
Short of reforming the very nature of human beings with some magic powder discovered in the chemistry labs of Harvard, there is a solution.
The basic conflict lies in the manner of funding. Nearly all entrepreneurs and investors (far more that you’d imagine) have a singular formula for capital. Money gets exchanged for shares in the company (“stock”) and the power lies with whoever owns the most shares. In even the most positive, benign relationship with mature people, this formula breeds suspicion and distrust.
Fortunately, there are many alternatives. My favorite is royalty deals.
I suspect these might even go back as far as Will and the theater in Shoreditch. In the simplest arrangements, investors put up “front-money” to cover the expenses of staging the play and were rewarded (hopefully) by being repaid a fixed percentage of the profits. However, it wasn’t long until some creative author/producer found a way to change this simple formula. They added everything (no matter how ridiculous) to the production costs, thus insuring there were no profits. The two sides finally evolved to a more honest financial model where the return to investors was based on ticket receipts, not profits.
Fast forward a few hundred years … Traditionally found in high-risk industries such as mining, film production and drug development, royalty financing is being seen more among technology companies and other early-stage firms with great growth potential.
Many entrepreneurs aren’t interested in forking over a large chunk of equity to venture capitalists or other investors for working capital. Usually, they also consider loans, but quickly discover that banks have made it onerous for young companies to obtain debt financing. They stumble on royalty structures and find then enlightened investors that share their enthusiasm for such arrangements.
The exact financing structure varies amongst the specific investment deals. One might couple royalty financing with a multiple-year amortized loan … or, attach a stock warrant as a safeguard in case the company becomes unbelievably successful.
However, generally the companies receiving the funds (technically a kind of loan) agree to pay a percentage of sales revenue, maybe 2% to 10% (depending on the actual products and gross margins), either over a specified time period or until a negotiated multiple of the investment is paid back.
As with any “solution” there are potential risks for the entrepreneur. The total cost of capital may become more expensive than bank debt, practically if the company does very well and the royalty agreement doesn’t contain a negotiated ceiling. And, like all loans, it's still possible for the company to default on them. However, the default provisions of royalty loans are generally milder than bank debt, and the payments (usually monthly) are variable not fixed, allowing the company flexibility for the usual ups and downs of business.
There are other major advantages. The entrepreneur doesn’t give up any equity or control in the initial deal, although there may be later “equity kickers” awarded to the investors, but far less than the controlling interest. Also, it’s much better than bank debt since the investors are “insiders” that want to see the company succeed and are usually far more tolerant than a bank should the company temporarily fall upon hard times. Bankers just sent in their “troubled company” VP’s and start liquidating and fast - to get every penny they can recover.
The entrepreneur will usually spend a little more on the preparation of royalty deals as they require an experienced lawyer and a good accountant that can explain the potential tax ramifications to investors. However, this can be mild compared to the tribulations the average entrepreneur experiences with investment professionals between the initial “handshake” and the final negotiations. In that interim, the investor will fill their term sheets with multiple, complex add-ons that sweeten the deal for them.
For investors, the big deal is they don’t have to fret about the dreaded “Exit Strategy”. As long as the royalties roll in, investors couldn’t care less whether the company does an IPO or gets sold to another company. A small negative – if the investor is an individual, the royalties will probably be considered ordinary income by the IRS – but for most investors this is a small price to pay for receiving handsome, monthly payments.
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