Royalty vs Loan for new start up

[rasar9]

Which case is better for a new start up company? To have an investor accept royalties or getting a loan with very interest rate. How does it effect the company growth?

 

[Samir]

From a cashflow basis, if all the amounts are the same, it really doesn't make a difference. Money out is still money out, whether it's going to a bank or an individual.

Now, that being said, it depends on how the royalties are treated when being paid. A mortgage can be expensed, but only for the interest portion whereas the entire royalties payment could be expensed. The investor would need to be issued a 1099 at the end of the year (I believe) and would be responsible for income tax in the amount received, but the business would be able to expense a lot more of the same cash going out. The balance sheet would also look healthier since there wouldn't be a huge long-term liability (the bank loan).

 

[Counterofbeans]

From the company's perspective, unless the loan had some really strange/fast repayment terms, I'd take the loan every day of the week & twice on Sunday for a startup company.

Royalties take cash right off the top, which can be brutal for a company trying to keep it's head above water

From an investor's perspective, I'd take the royalties and smile every time I walked out to the mailbox...

 

[Samir]

From the company's perspective, unless the loan had some really strange/fast repayment terms, I'd take the loan every day of the week & twice on Sunday for a startup company.

How do you figure if the amount being paid back is the same? Servicing debt in the form of a principle and interest doesn't change the cashflow.

 

[Counterofbeans]

How do you figure if the amount being paid back is the same? Servicing debt in the form of a principle and interest doesn't change the cashflow.

The timing of the cash flow(s) is what I would be concerned about. Granted, this is a super generic question without details, but, in my mind, I hear royalty, I think, "for each unit sold, I'm going to pay "$X" per unit" and this payment would likely be made monthly or something equally fast.

Further, with a royalty, the faster you ramp up sales, the more you owe. I would think this especially challenging for a start-up, as not only do they often need all the cash they can get their hands on, but they would also need it to build inventory (assuming a manufacturing company, of course). A royalty setup could potentially, & completely, torch that, severly limiting the growth potential of the company.

I would think that, a loan, especially to a start-up company, could stretch out the re-payment terms, perhaps over years, & such wouldn't fluctuate with sales.

I struggle to think of any startup that would be pleased with a royalty setup. I'd go negotiate a loan and smile at the certainty of the cash flows.

Maybe I'm missing something, but that's what I would think.

 

[bklynboy]

I think they are referring to using royalty financing which is becoming very common on new startups. The concept is that a portion of revenue is paid back over time - it is not indefinite nor is structured where they take a set percentage off the top. Generally the royalty continues until a set period of time expires or the financing is repaid with an interest rate and generally has a ceiling on what is repaid periodically. It does work similar to a loan and does not cannibalize the firms need for expansion and growth. Generally this is used where loans are not easy to secure since the rate is generally higher on royalty financing. Effectively its a loan secured by royalty proceeds.

 

[Samir]

I think they are referring to using royalty financing which is becoming very common on new startups. The concept is that a portion of revenue is paid back over time - it is not indefinite nor is structured where they take a set percentage off the top. Generally the royalty continues until a set period of time expires or the financing is repaid with an interest rate and generally has a ceiling on what is repaid periodically. It does work similar to a loan and does not cannibalize the firms need for expansion and growth. Generally this is used where loans are not easy to secure since the rate is generally higher on royalty financing. Effectively its a loan secured by royalty proceeds.

See, this is what I was thinking in reference to the original post. And from a cashflow standpoint, it's the same.

The timing of the cash flow(s) is what I would be concerned about. Granted, this is a super generic question without details, but, in my mind, I hear royalty, I think, "for each unit sold, I'm going to pay "$X" per unit" and this payment would likely be made monthly or something equally fast.

Further, with a royalty, the faster you ramp up sales, the more you owe. I would think this especially challenging for a start-up, as not only do they often need all the cash they can get their hands on, but they would also need it to build inventory (assuming a manufacturing company, of course). A royalty setup could potentially, & completely, torch that, severly limiting the growth potential of the company.

I would think that, a loan, especially to a start-up company, could stretch out the re-payment terms, perhaps over years, & such wouldn't fluctuate with sales.

I struggle to think of any startup that would be pleased with a royalty setup. I'd go negotiate a loan and smile at the certainty of the cash flows.

Maybe I'm missing something, but that's what I would think.

I see where you are coming from, but I still think a royalty wins out even in the scenario you presented.

From day one, you're not going to have a large amount of sales, so a fixed debt service hurts rather than helps cashflow. If you're only paying based on a percentage of sales, you're only paying when you have revenue. As revenue ramps up, this may become an issue, but at that point in time there's enough resources to get a traditional loan and reduce the cashflow cut by a percent or two.

 

[Counterofbeans]

I think they are referring to using royalty financing which is becoming very common on new startups. The concept is that a portion of revenue is paid back over time - it is not indefinite nor is structured where they take a set percentage off the top. Generally the royalty continues until a set period of time expires or the financing is repaid with an interest rate and generally has a ceiling on what is repaid periodically. It does work similar to a loan and does not cannibalize the firms need for expansion and growth. Generally this is used where loans are not easy to secure since the rate is generally higher on royalty financing. Effectively its a loan secured by royalty proceeds.

Yeah, I can understand how that would change the dynamics. As I said in my reply, the question is very generic. I'm used to situations where it's a fixed amount per unit---something that you'll often hear Kevin O'Leary request when he's investing--and it's no surprise in my mind that the owners seldom, if ever, take his deals.

This makes me think that this, "new" structure has been created because of the concerns that O'Leary runs into, which is what my concern is.

Further, see comment below.

See, this is what I was thinking in reference to the original post. And from a cashflow standpoint, it's the same.
I see where you are coming from, but I still think a royalty wins out even in the scenario you presented.

From day one, you're not going to have a large amount of sales, so a fixed debt service hurts rather than helps cashflow. If you're only paying based on a percentage of sales, you're only paying when you have revenue. As revenue ramps up, this may become an issue, but at that point in time there's enough resources to get a traditional loan and reduce the cashflow cut by a percent or two.

Ehh, I'm not with you here.

Technical tidbit: I was referring to a fixed amout per unit, not a % of sales

If you don't have sales, the game is pretty much up anyways. The idea that a fixed service debt hurts you means that one would have had to make a serious mistake in estimating sales and the repayment of the loan at inception.

Further, the last thing a startup wants is to cannibalize sales to pay for royalty (& I'm talking about the royalty per unit situation, not some creative royalty agreement). Startups frequently demand that an emphasis be put on cash flow & a royalty agreement that ramps with sales just isn't a wise move in my mind.

I can definitely see a situation where someone can get creative with a royalty agreement and make it mimic a loan. And that might have a lot of justification.

But then I would simply ask, "why not just go get a loan then?"

I mean, if all we're talking about is a loan that's, "secured by royalty proceeds," then isn't that just a loan with creative repayment terms?

If a standard/typical royalty agreement is preferred, why don't we see loan agreements modified to mimic a royalty agreement?

I think that if you look back over successful startups over the last, say, 40-50 years, you'd be hard pressed to find more successful companies that started out with a royalty agreement than with a loan. As a matter of fact, I'd be shocked if they were even close...

I still vote for loan over royalty.

 

[bklynboy]

But then I would simply ask, "why not just go get a loan then?"

I mean, if all we're talking about is a loan that's, "secured by royalty proceeds," then isn't that just a loan with creative repayment terms?

If a standard/typical royalty agreement is preferred, why don't we see loan agreements modified to mimic a royalty agreement?

The issue startups run into is that banks are not as willing to lend and has become more of an issue of late where even "typical" loans have extended timelines and hefty documentation requirements. Investors also place a premium on unsecured loans by way of a note so these become quite costly. A simpler approach that was developed was through the royalty financing route as these are quicker to secure and provide the same level of liquidity the firm may need. You are correct its not always the best route to take but just another venue of financing available especially when cash is needed quick (though the cost will likely be higher than conventional loans).

You are right the post provided limited insight into the reason they are considering it and I would also agree the cost is higher - but the pros such as not including as a liability on the balance sheet (its not debt but a contingent liability), quick access to funds and repayment contingent on revenues do have consideration. This is not a simple decision but one that must weigh all the facts. All things being equal a conventional loan is my preference.

 

[Samir]

Technical tidbit: I was referring to a fixed amout per unit, not a % of sales

If you don't have sales, the game is pretty much up anyways. The idea that a fixed service debt hurts you means that one would have had to make a serious mistake in estimating sales and the repayment of the loan at inception.

Further, the last thing a startup wants is to cannibalize sales to pay for royalty (& I'm talking about the royalty per unit situation, not some creative royalty agreement). Startups frequently demand that an emphasis be put on cash flow & a royalty agreement that ramps with sales just isn't a wise move in my mind.

I can definitely see a situation where someone can get creative with a royalty agreement and make it mimic a loan. And that might have a lot of justification.

But then I would simply ask, "why not just go get a loan then?"

It's definitely a different animal when you're talking about a fixed royalty per item as that will balloon very quickly with a ramp up in sales. But it's only going to be outpacing a traditional loan if someone is stupid enough to agree with such terms. Anyone looking at both options will be pushing for a royalty that is lower than a loan for at least one year, if not longer.

What's the definition of a startup if it already has sales? Every business starts with zero sales. This is when cashflow is the most important since revenues are low. Having a royalty that ramps up in a fair manner that's below the cash requirement of a traditional loan is a real winner here. But the royalty has to be fair or it will run far more expensive than a traditional loan as you've mentioned.

And in cases where a loan wins against a royalty agreement in terms of short-term cashflow, that's a no brainer--traditional loan all the way.

I think the main reason royalties are not used as much is because a loan has the security of UCC filings and the legal structure to secure the loan. A royalty has no such protection when structured to mimic a loan, and even less protection when just a cut of sales.