Revenue Royalties – The Easiest Way to Fund Most Young Companies

Revenue Royalties - The Easiest Way to Fund Most Young Companies

As an investor, it’s become apparent there are major drawbacks to two of the common means of funding young companies: selling ownership rights (C-corp stock or LLC membership) and issuing a note (convertible or not) — i.e. borrowing money from investors. The good news is I’ve found a neat solution as an investor which removes these drawbacks. It's called Revenue Royalties. I want to focus on this issue this week because I’ll be speaking about this publicly over the next few weeks and want to create an opening for you to hear me on this topic.

Selling ownership (stock in a C-corp or membership in an LLC) leaves you with a reduced incentive to be successful and an enlarged group of investors who need to be kept informed. You may interpret their input as useful coaching or as meddling interference. Either way, dealing with co-owners takes time. You also may want to reserve the sale of ownership rights to a point later in the growth of the company when the company is worth a great deal more. At an early stage, selling ownership may require selling a large share of the company, more than you want to sell.

Taking a loan out from investors (either a straight loan or a convertible note) has the problem that you have to pay it back at a fixed time with a fixed rate of interest. If the company develops more slowly than you expect (highly likely) then you may be stuck with an overdue loan and very unhappy investors, or at very best with burdensome payments that limit the amount of money you have available for payroll, marketing expenses and your family.

Having participated in both these kinds of deal, I know how painful they are both for the investor and for the entrepreneur.

There’s a better way

In the book" Angel Financing for Entrepreneurs" by Susan L. Preston, the author explains what sophisticated angel investors want, including:

Team: seasoned management, with successful start-up experience
Passion: Investors are looking for entrepreneurs with passion for their ideas
Coachability: a willingness to take and apply sound advice
Financial projections: Business plan with detailed financial projections for 3 to 5 years
Profitability: Unlike in the boom, a clear path to profitability

I would add a few other things such sophisticated investors want:

A compelling solution to a bonafide problem (a painkiller not just a vitamin)
Intellectual property (proprietary products or services) with barriers to entry
Sustainable competitive advantage
A clear and believable go-to-market plan
Willingness to sell 20% to 40% of the company in the first angel round (after friends and family)
An exit possibility (willingness and opportunity to sell the company) such as a public offering or sale of the company that will pay investors at least 10 times their investment within 5 years. This high rate of return compensates sophisticated investors for the fact that on the average 80% to 90% of early stage companies never get sold and therefore don’t pay their investors back at all.

What’s wrong with this picture?

The problem is that 1) most really creative entrepreneurs don’t have a fully seasoned management team, and 2) they don’t have real intellectual property with barriers to entry such as a patent or exclusive alliances. What’s more 1) most entrepreneurs are not willing to sell 20% to 40% of their company in the first angel round of investing and even if they are, 2) there is no real market to sell the company at a high enough price to pay investors at least 10 times their investment.

At least 80% of new innovative companies, in my experience, suffer from these limitations when seeking investment, even though they’re passionate about their businesses. That’s one of the main reasons why only about 3% of companies who apply for sophisticated angel investment end up getting it.

So what’s the answer for the passionate 80%?

The good news is there’s an entirely different way to raise funding for 80% of entrepreneurs who don’t qualify for investment by sophisticated investors such as professional angels or venture capitalists, beyond family, friends and credit cards. Here are the basic qualifications:

  1. The product or service is exciting (not necessarily compelling) and makes a positive contribution to the world.
  2. There is a clear differentiation from competition (not necessarily with barriers to entry).
  3. There is a large market for the product or service that can afford it (a total available market whose size is at least 4 times expected sales in the fifth year.)
  4. The company has market validation of some kind (growing revenues or market testing or other similar companies that have succeeded.)
  5. There is a go-to-market plan (a clear realistic plan to market and sell the product.)
  6. There is a natural affinity group (people who can relate to the founder and might use the product themselves.)
  7. The affinity group has money to invest.
  8. The product or service is easily understood by the affinity group.
  9. Company has a charismatic or at least personable leader with high energy and passion for the company.
  10. Company is already in revenue or expect revenue within two years.
  11. There is a believable revenue projection showing rapidly increasing revenue (not necessarily profitable) over at least 5 years.
  12. The amount of investment capital needed in the first year is not more than 10% of year-5 revenue projection.
  13. The team includes at least one “execution master” with sales and marketing experience in a related business, separate from the founder.

This looks like a long list, but if you read through it as an entrepreneur, you may find that your company fits like a glove. To borrow a famous statement, “If the glove fits, you must not quit.”

As I’ve found observing successful investment pitches, there is plenty here to interest “non-sophisticated” investors. The great news is, if your company can qualify per the above list:

  1. You don’t have to sell the company at any particular time, or at all.
  2. You probably don’t have to sell any ownership rights (stock or membership), certainly not more than 20% of the company, and
  3. You don’t have to borrow money that has to be paid back at a fixed time with a fixed rate of interest.

How is this wonderful news possible, you may be asking?

The answer is to seek loans of various kinds where the repayment is based on actual revenue. You don’t have to pay it back until your company has sufficient revenue to afford paying it back. The formulas for payback can get complicated, with the amount of revenue devoted to payback small at first, rising, and then dropping off again. Formulas may also include adjusting gross revenue by subtracting predictable expenses that vary directly with revenues, such as direct cost of goods. I’ll have to go into greater detail with you at a later time on this.

These types of lenders (who’ll be happy to be paid back out of revenue) are usually local, non-professional as investors, and usually found among people in your natural affinity group, though not necessarily people you know. So we call this method “Community-based revenue sharing” or revenue royalties.

It’s not surprising that this works. Motion pictures are usually financed in part this way. Charities are funded from contributors who don’t expect any financial return at all but have a personal affinity to the cause. So combine the way motion pictures are financed with the way successful charities are funded and … viola. There’s a way into the sunlight.

I’ll cover much more about Revenue Royalties - “community-based revenue sharing” in upcoming blog posts. In the meantime, please load me up with questions as comments to this blog. I’ll answer all of your questions.

Key takeaway: If you are in that 80% of young companies that are passionate about their product and can align your company to the 13 qualifications, then you may be a fit for Revenue Royalties - “community-based revenue sharing”. Now, go to work and find the money you need to grow.