Investing in startups is an exhilarating yet risky endeavor. While the potential for high returns can be alluring, the reality is that many startups fail to thrive, let alone survive. In this volatile landscape, traditional investment instruments like equity and convertible notes have been commonplace. However, a newer financial instrument has emerged on the startup scene, offering a different approach to investment: convertible royalties. In this article, we’ll explore what convertible royalties are, their advantages, disadvantages, and how they compare to more traditional investment options.
Understanding Convertible Royalties
What Are Convertible Royalties?
Convertible royalties, also known as revenue-based financing or royalty-based financing, are a relatively recent addition to the startup funding toolkit. Unlike equity, where investors receive a share of ownership in the company, or convertible notes, which are loans that can convert into equity, convertible royalties operate differently.
In a convertible royalty arrangement, an investor provides funding to a startup in exchange for a percentage of the company’s future revenue, typically until a predetermined cap or a specific return multiple is achieved. Once this cap is reached, the royalty agreement typically terminates.
How Do It Work
Let’s break down the mechanics of convertible royalties:
- Investment: An investor provides capital to a startup. In return, the investor is entitled to a percentage of the startup’s gross revenue, usually on a regular basis, such as monthly or quarterly.
- Revenue Share: The startup begins generating revenue from its operations, which can include sales, subscriptions, or any other income source. A predetermined percentage of this revenue is paid to the investor as a royalty payment.
- Cap or Termination: Convertible royalties often have a cap or a predetermined return multiple. Once the startup has paid the investor up to this cap, the royalty payments typically cease, and the arrangement concludes.
- Exit Events: In some cases, convertible royalties may convert into equity if the startup experiences an exit event, such as an acquisition or an initial public offering (IPO). The conversion terms are outlined in the agreement.
The Advantages of Convertible Royalties
1. Alignment of Interests
Convertible royalties align the interests of the investor and the startup. Unlike equity, where investors share ownership and may seek a speedy exit, convertible royalties connect the investor’s return directly to the startup’s performance. This encourages investors to support the company’s growth and success over the long term.
2. Reduced Dilution
One of the primary advantages of convertible royalties is that they can potentially result in less dilution for founders and early stakeholders. Since investors in convertible royalties do not receive ownership stakes, the startup’s founders can retain a larger percentage of the company’s equity.
3. Cash Flow Friendliness
Startups are often cash-strapped, and convertible royalties can be more cash flow-friendly than traditional equity or debt financing. Instead of making fixed debt payments or issuing equity, which requires ongoing dividend payments or share buybacks, startups only pay a percentage of their revenue when they have revenue to share.
4. Flexible Terms
Convertible royalty agreements can be highly flexible. Terms can be tailored to the unique needs of the startup and the preferences of the investor. This flexibility allows for creative deal structuring that suits both parties.
5. Potential for Lower Cost of Capital
Convertible royalties might offer a lower overall cost of capital for startups compared to other forms of financing. This is particularly true if the startup experiences significant revenue growth, as the royalty payments are a fixed percentage of revenue and do not change with the increase in valuation.
The Disadvantages of Convertible Royalties
1. Complexity
Convertible royalties can be more complex to negotiate and structure than traditional equity or debt investments. Determining the appropriate percentage of revenue to share, the cap, and the termination conditions can require extensive negotiations.
2. Potential for High Costs
While convertible royalties may offer lower costs of capital in certain scenarios, they can become expensive if a startup experiences rapid revenue growth. As the percentage of revenue owed to the investor remains fixed, the actual dollar amount paid to the investor can become substantial.
3. Revenue Dependency
Convertible royalties tie a startup’s financial obligations directly to its revenue. This means that during periods of low or no revenue, the startup may still be obligated to make royalty payments, which can strain its finances.
4. Investor Returns Uncertainty
Investors in convertible royalties face uncertainty regarding their returns. Unlike equity investments where returns are tied to the company’s valuation, the returns from convertible royalties are dependent on the startup’s revenue. If the startup struggles to generate revenue, investors may receive lower returns or even incur losses.
Comparing Convertible Royalties to Traditional Instruments
Convertible Royalties vs. Equity
- Ownership vs. Revenue Share: Equity investments provide ownership stakes in the company, entitling investors to a share of profits and decision-making power. Convertible royalties, on the other hand, do not grant ownership but provide a share of revenue.
- Alignment of Interests: Convertible royalties better align the interests of investors and startups with a focus on revenue growth. Equity investors may prioritize exit opportunities.
- Dilution: Convertible royalties typically result in less dilution for founders and early stakeholders, as they do not involve issuing new shares.
Convertible Royalties vs. Convertible Notes
- Debt vs. Revenue Share: Convertible notes are debt instruments that can convert into equity. Convertible royalties are not debt; they involve a share of revenue.
- Timing of Conversion: Convertible notes often have conversion triggers tied to specific events, such as a funding round. Convertible royalties are based on revenue and do not depend on external events.
- Interest vs. Revenue Share: Convertible notes accrue interest, which can increase the total repayment amount. Convertible royalties do not accrue interest but instead involve a fixed percentage of revenue.
Conclusion
Convertible royalties have introduced a new dimension to startup financing, offering a creative alternative to traditional equity and debt instruments. They align investor returns with a startup’s revenue, potentially reduce dilution for founders, and provide cash flow flexibility. However, they are not without complexities and potential drawbacks, such as uncertainty regarding investor returns and the risk of high costs during periods of rapid revenue growth.
Whether convertible royalties are the right choice for a startup or investor depends on various factors, including the startup’s growth trajectory, revenue model, and the investor’s risk tolerance and return expectations. As with any financial arrangement, careful consideration, negotiation, and legal counsel are essential to structure convertible royalties effectively. As the startup funding landscape continues to evolve, convertible royalties offer another tool in the toolkit for those seeking to support and invest in innovative ventures
