What is Royalty-Based Financing?

Investing in a business on the condition of receiving a percentage of the ongoing operating profits, until the principal investment and an additional prefixed cap is recovered, is called Royalty Based Financing (RBF), or Revenue Based Financing. RBF cycles may last from 2 to 5 years.

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How Does Royalty-Based Financing Work?

RBF occupies the sweet spot between angel investments acquired by selling off stakes in the company, and bank loans that require considerable collateral assets and huge interests. Theres no trading of equity in RBF. An equity warranty suffices to secure investments. Theres no need to appoint an Investor Board Representative, or involve the investors in other business decisions, conduct elaborate valuation exercises or add personal assets as liabilities. 

History of RBF 

Arthur Fox proposed this revolutionary investing model in the late 1980s to help emerging businesses in New England. Its since been used to manage debt-financing in the energy sector. Fox formed his own RBF fund in 1992 based on the tremendous success of this model, and was able to replicate his early success with new financing ventures. Fox licensed the idea as a proprietary financing model in 2011. Cypress Growth Capital LLC in Dallas, Texas, was the first and remains its biggest licensee, managing more than $50 millions dollars in investments. RBF industry is represented in trade by the Revenue Capital Association. While some firms use the model locally, others invest nationally. Crowdfunding platforms call modern variations of RBF as Revenue Sharing. While RBF is a significant improvement on traditional lending models, it has two caveats to be brought into play.

1. The business needs to generate revenue to make payments to investors.
2. Considerable gross profit margins to cover loan repayments while keeping the business operational.

Investors and businesses have their goals aligned in the RBF model. Increase in revenue leads to better gains for investors and faster repayment of loans for businesses. Conversely, declining revenues lead to poor returns. This is an advantage for businesses, as a fixed loan payment requires diversion of funds to banks even when the revenues are on the decline. By factoring loan repayments in accordance with revenue generated, businesses can tide over rough patches with ease. 

Cost of Capital Savings in RBF 

Although the Cost of Capital is lower in RBF models, it entails the following advantages:

1. Lower interest rates.
2. Lower legal fee.
3. Since the investment is categorized as a loan, it confers tax advantages.

This is possible due to the risk shouldered by the investor. As the earnings are tied into a percentage of the profits, the sale of the firm isn't required in the eventuality of the business failing to garner profits. Although RBF works out as more expensive than traditional banking, new and emerging businesses find it more beneficial in the long term than giving in to the stringent assets and collateral damage securement practices of banks.