Royalty-Based Financing Definition
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.
A Little More on Royalty-Based Financing
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. There’s no trading of equity in RBF. An equity warranty suffices to secure investments. There’s 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. It’s 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.
- The business needs to generate revenue to make payments to investors.
- 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:
- Lower interest rates.
- Lower legal fee.
- Since the investment is categorised 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.
References for Royalty-Based Financing
Academic Research on Royalty-Based Financing
Intellectual Alchemy: Securitization of Intellectual Property as an Innovative Form of Alternative Financing, Gabala Jr, J. M. (2003). Intellectual Alchemy: Securitization of Intellectual Property as an Innovative Form of Alternative Financing. J. Marshall Rev. Intell. Prop. L., 3, i. This paper takes a look at intellectual property as collateral assets in the alternative financing sector.
When You Wish Upon a Star: Explaining the Cautious Growth of Royalty-Backed Securitization, Fairfax, L. M. (1999). When You Wish Upon a Star: Explaining the Cautious Growth of Royalty-Backed Securitization. Colum. Bus. L. Rev., 441. This article provides the history, rise, and adoption of the Royalty Backed Securitization financing model.
Network effects and technology licensing with fixed fee, royalty, and hybrid contracts, Lin, L., & Kulatilaka, N. (2006). Network effects and technology licensing with fixed fee, royalty, and hybrid contracts. Journal of Management Information Systems, 23(2), 91-118. This paper evaluates the issues of RBF royalties in the licensing of innovations in technology.
Ensuring Horizontal Equity: Challenge before the Thirteenth Finance Commission, Das, K., & Mishra, A. K. (2009). Ensuring Horizontal Equity: Challenge before the Thirteenth Finance Commission. Economic and Political Weekly, 14-17. This paper focuses on the challenge of interstate distribution of resources for the Thirteenth Finance Commission.
Evaluation of true government take under fixed and sliding royalty scales in Nigerian oil industry, Isehunwa, S., & Uzoalor, E. I. (2011). Evaluation of true government take under fixed and sliding royalty scales in Nigerian oil industry. Australian Journal of Basic and Applied Sciences, 5(3), 735-741. This paper evaluates RBF and the government royalty scales in the Nigerian Oil Industry.
” Focus on Banking and Finance” piece on royalty–based financing, where investors, Zicarelli, R. (2004). ” Focus on Banking and Finance” piece on royalty-based financing, where investors. This paper focuses on RBF where investors get a fixed percentage of royalty in the finance and banking sector.
Resource-based FDI and expropriation in developing economies, Hajzler, C. (2014). Resource-based FDI and expropriation in developing economies. Journal of International Economics, 92(1), 124-146. This journal examines expropriation data on FDI across 38 developing countries’ economies.
A Price-Based Royalty Tax?, Clausing, K., & Durst, M. (2015). A Price-Based Royalty Tax?. This paper examines the merits and demerits of royalty taxes based on prices.
Sadaqah-Based Crowdfunding Model For Microfinancing And Health Care, Lutfi, M. A., & Ismail, M. A. (2016). Sadaqah-Based Crowdfunding Model For Microfinancing And Health Care. This paper focuses on Sadaqah – Based crowdfunding aspect of the Islamic microfinancing model in healthcare.
Bridging Trade Finance Gaps, Suominen, K., & Lee, J. (2015). Bridging Trade Finance Gaps. Brookings Institution, January. This paper focuses on the gaps in financing faced by small and medium enterprises.
Equity-based crowdfunding outside the USA, Dehner, J. J., & Kong, J. (2014). Equity-based crowdfunding outside the USA. U. Cin. L. Rev., 83, 413. This journal takes a look at financing via equity based crowdsourcing outside the USA.