(by Marco Vangelisti)
Royalty financing, whereby investors receive a percentage of the revenues, relieves the entrepreneur of the implicit pressure early equity investing creates to grow rapidly towards an “exit”. Royalty financing is aligned with the ethos of Slow Money and allows for broader participation on the part of Slow Money investors while allowing the business to grow at its own pace and avoid dilution of early investors.
Slow Money is a movement sparked by the idea that we have to find a better way to work with money if we want to bring forth a restorative economy which respects our communities, values the uniqueness of place and restores the fertility of the soil. Such movement has found expression in many groups around the country looking for ways to catalyze the flow of investment capital towards local food and farming enterprises.
Entrepreneurs obtain capital to create and grow their business from different sources and in different forms based on their connections, the type of business they are building and its stage of development.
A business goes through many stages from the initial idea to a thriving profitable enterprise.
- Proof of concept
- Product development
- Entering the market
- Approaching profitability
Every business starts with an idea, often created by the recognition of an unmet need or of a problem in need of solution. That idea must be tested to determine if the perceived need or problem can generate enough demand to support a new business. Prototyping has to do with creating an early version or the product or service, let’s call it offering, that can be tested by actual customers willing to provide feedback and allow for the refinement of the offering and its specific features.
The product development stage is entered when the features of the offering have been sufficiently defined and the attention shifts to production of the offering in the quantity and quality required by the market. Towards the end of the product development period, the offering will be made available to the market thought sales channels (directly or through distributors).
At that point, the business will most likely still be operating at a loss and only when sales reach a certain volume will the business reach profitability. Once a business is profitable, it might require additional capital for expansion. Capital is needed for all stages of development of a business until it becomes profitable and therefore self-sufficient.
As a general rule, the earlier the stage of the business, the greater the risk and therefore the harder it is to obtain capital. Capital for the very early stages typically comes from the entrepreneur’s own financial resources or from friends and family members.
The first “outside” investors are sometimes called angel investors and typically provide early stage equity capital, in other words, they obtain an ownership stake in the enterprise for the capital they provide. They also typically provide specific industry and management expertise. Angel investors might invest in a business that is either prototyping or in the product development stage. They tend to be wealthy individuals with extensive experience in finance in general and private equity investing in particular.
Venture capitalists tend to invest when the business is in the late stages of product development or is already generating revenues. Again, venture capitalists obtain an ownership stake in the enterprise for their investment and sometimes require participation in the managing of the business, either by taking key senior management positions or seats on the Board of Directors. Private equity investors tend to invest in businesses that have a track record of success and an established position in the marketplace.
An established business that has reached profitability might be able to obtain loans or lines of credit either from banks, financial institutions or investors.
Angel investors and venture capitalists take an ownership stake in businesses with the ultimate goal of generating a financial return. The high risk associated with investing in early stage businesses has to do with the fact that most of them do not succeed and are eventually terminated, in which case equity investors lose the capital they invested. Early stage investors expect a significant percentage of the businesses in which they invest to fail, and therefore count on the few that succeed to generate outsized returns to cover the loss of their investments in less successful enterprises and generate a positive overall return.
That’s why angel investors and venture capitalists are interested in businesses with the potential to grow very rapidly and that offer an “exit”. The “exit” is a liquidity event that allows investors to get their money back. The typical exists are either the sale of the business to a larger enterprise or an initial public offering (IPO) of the shares of the business on a stock exchange.
The typical expectation for early stage equity investor is a 10x in 5 years. That means, they expect to receive 10 times the amount they invested within 5 years. Assuming 7 out of 10 of the early stage businesses they invest fail and three grow rapidly and are sold or go public after 5 years for 10 times the value of the initial investment, then the return on their portfolio of 10 investments will be around 25% per year.
Slow Money seeks to catalyze the flow of investment capital towards food and farming enterprises. These enterprises tend to be small to medium, often family owned, and attuned to the place and community in which they operate. Very few of them have either the desire or the opportunity to rapidly scale and are therefore of little interest to traditional angel investors or venture capitalists looking for an exit strategy and the prospect of large investment returns. Slow Money investments are primarily made to support enterprises that enrich the vitality of the local food shed and contribute positively to their local economy and community.
Slow Money is also attempting to broaden the concept of “investor” to include the vast majority of the community members, most of whom have limited experience investing directly in businesses and early stage enterprises. Only a very small minority of the people attracted by the message of Slow Money is familiar with early stage equity investing and can assume the financial and liquidity risk associated with it. Royalty financing is therefore appealing to a much larger group of potential Slow Money investors.
Royalty financing is an arrangement whereby investors provide capital to an enterprise with revenues and approaching profitability or already profitable. The investors are repaid on a quarterly basis as a percentage of the gross revenues of the business until the initial capital plus a premium determined in advance is returned.
For example, let’s assume an entrepreneur needs $100K in 2012 to fund the expanding operations of her business until 2014 when the business will turn profitable. Royalty payments of 3% of revenues start in 2013 and continue until the investors receive $150K (the original $100K plus a premium of $50K). If the actual revenues match the projected revenues the investors will be repaid in full by the end of 2017 and will obtain a return of 11.4%. If the actual revenues fall short of the projected revenues it might take longer to repay the investors and the return will therefore be lower. For example, if the actual revenues are only 70% of projections, the investors will be fully repaid in 2018 and receive a return of 9.9%. If the actual revenues are only 50% of projections, the investors will be fully repaid in 2019 and receive a return of 8.7%
|total royalty payments||$150,000|
It is useful to contrast the features of royalty financing with those of early equity investing by angel investors or venture capitalists.
First, royalty financing does not entail ownership and therefore the original owners of the business do not get diluted by raising capital through royalty financing. Investors providing royalty financing have an interest in seeing the business succeed but since they are paid based on a percentage of revenues do not need to have a say in how the business is run or how fast it reaches profitability. Angel investors and venture capitalists on the other hand often have a say in managing the company or in determining the composition of the board.
Royalty financing is self-liquidating and independent of how fast the business reaches profitability. Both liquidity risk and investment risk are greatly mitigated. Early equity investing on the other hand is very illiquid and in fact only a liquidity event in the form of a sale or initial public offering allows early equity investors to realize an investment return. Since the only way to return capital to early equity investors requires an unusual event (sale or public offering) predicated on rapid growth and on reaching a substantial scale, the investment risk is very high and comes with the expectation for a commensurately large investment return.
Entrepreneurs who want to determine the pace of growth of their business based on a healthy balance between work and family life and the ultimate size of their business based on a sense of appropriate scale and a sense of place might find royalty financing more suitable than early stage equity investing especially if the investors are outside their close network of family and friends and therefore might not share the entrepreneurs’ values and priorities.
In summary, royalty financing offers an attractive alternative to early stage equity capital especially suited to businesses that want to avoid the pressure of having an “exit strategy” and the attendant demand for rapid growth. Royalty financing being self-liquidating and significantly less risky than early equity investing, offers the opportunity for a much broader participation of potential Slow Money investors.
 Assuming they invest $1M in each of 10 businesses, seven fail and three sell for $10M each five years later, their initial investment of $10M in the 10 businesses turn into $30M in 5 years corresponding to an annualized return of 25%