Royalty Based Finance

In practice, however, there are always complications. Pure equity investors are hard to find. It costs more these days to finance a growing company, and it takes longer for it to become profitable. For investors to put money into a company, they need to be able to foresee an exit. A simple summation shows that: large amount of finance x big risks x long wait = extreme return requirements. Investors only become interested in a company if they can earn 10 times or more on their principal. The irony is that especially when a company does well, things can go wrong. Imagine an investor puts in 200,000 for 20% of the company’s shares. After five years (on the basis of future cash flows), this is worth 4 million. How is an entrepreneur supposed to come up with this amount of cash? This is only possible if the entrepreneur sells the whole company.
In the new emerging markets, this problem is even greater. In these countries, small and medium sized enterprises (SMEs) are almost never sold, and the capital markets are so underdeveloped that entrepreneurs can hardly afford to buy their shares back. The result is that the entrepreneur often doesn’t pay what also happens frequently in developed markets. Going to court is pointless, since judges don’t understand what equity is, and they will recalculate the profit to interest, and make the investor look like a usurer. Furthermore, the concept of “profit” is not always clear. The tax authorities in many emerging markets are not the friend of the entrepreneurs. Large companies with good connections mostly pay little or no taxes. For this reason, the tax authorizes try to milk the SMEs for all they are worth. The investor has a series problem therefore if they ask the same kind of questions as a tax inspector would. Entrepreneurs in many countries are used to avoiding these types of questions and don’t trust people who ask about the profitability of their businesses.

There are several solutions for these earlier mentioned problems. One of the most common is the use of subordinated loans. Imagine that an entrepreneur needs 200,000. The investors puts 10,000 in shares and in this way gains their “share” in the company (say, 30%). The rest of the financing can vary between 100,000 and 300,000, without having to adjust the percentage of shares. Funds are granted on a need basis, and paid back depending on the cash flow situation. Interest on the subordinated loans is somewhat higher than on a normal bank loan. If the company does well, the investor gets the bulk of her money back so that it is no longer “exposed”. The investor will have to wait longer for the “big hit” but this is mostly not an issue.
For new emerging markets, this construction is mostly not good enough. In these countries, people should try to avoid profit sharing and exits as much as possible. The financing method which is used in these countries is called “Royalty Based Finance”. Here follows an overall description of the construction:
• Imagine that an entrepreneur wants to raise 200,000 and offers 30% of her share capital.
• The equity is taken up immediately, 30% for 10,000, with the agreement that the entrepreneur has the option to buy back the shares at any given moment for three times their value, i.e.; 30,000.
• The rest of the money becomes available in the form of a subordinated loan with a “soft” interest rate (interbank or prime). The loan is paid back in five years with a grace period of one year.
• In order to make a profit, the entrepreneur pays a small royalty over the sales, or the forecast sales, chosen by the investor. This procentage lies between 0.5 and 2% depending on the type of business.
• The royalty payments continue until all the loans are repaid and the shares are bought back. Shares can only be bought back when the loans are paid back and the royalty obligations are redeemed.
Example:
The following is an an example of an enterprise which borrows 200,000 at an interest rate of 5% and a royalty of 1%. In this case the IRR for the investor on the loan and equity part is 6% and the IRR on the total financing is 12%. The royalty payments will amount to 30,000 in year six, and this amount is equivalent to the buyback amount of the investors shares package.

Advantages of the Royalty-based finance system:
The advantage of the royalty system is that the return on investment is spread over the term of the financing. A small amount is paid from the beginning, and the size of the payments increase as time goes on. Ultimately, it is cheaper for the entrepreneur to pay the investor back and repay the loan than to keep paying royalties.
Advantages in a nutshell:
• The entrepreneur makes regular payments
• Payments increase in line with increases in sales
• The exit is much simpler
• Supervision is much easier
• Differences in opinion are avoided
• Entrepreneur can regain control over their enterprise without much hassle
• Its easy for the investor to estimate the cashflow from before-hand
• The enterprise doesn’t need to be sold in order to make a profit
• If the enterprise is sold, the investor gets a share of the proceeds
• Its easier for entrepreneur and investor to maintain their “friendship”
• The probability of “gain” by the investor increases substantially
• Problems with estimating the profit are avoided
• Problems estimating the value of the company via an exit are prevented
• Problems with financing the buyback by the entrepreneur are prevented
• The whole investments’ exposure to risk is reduced
• Adjustments to the division of shares are prevented as much as possible
All in all, the royalty finance system has so many advantages over “real” equity, that, especially in new emerging markets, the advantages far outweigh the disadvantages, with the caveat that investors need to show some restraint when determining the royalty percentages.