Royalty-based financing is a loan in which repayment is based on the borrower’s future revenue. Rather than fixed payments, the payments fluctuate with the borrower’s revenue performance.
The loan payments are variable, the term is also variable. Payments are made until the lender receives a pre-determined multiple of the original loan or achieves a pre-determined internal rate of return (IRR).
Royalty-based financing originated in the energy and mining industries as a source of debt financing. From there, it expanded into the life sciences industry. In recent years, it has expanded into other technology as well as non-technology sectors.
The term “royalty-based financing” is often used interchangeably with revenue-based financing. At Find Venture Debt, we use “royalty-based financing” exclusively for life sciences since that industry has unique characteristics and lenders that primarily or solely focus on the sector.
The term “royalty” is used in multiple ways in life sciences financing. In many cases, a company’s drug or medical device is based on technology licensed from a university, research institute or inventor. The company is the licensee and pays a royalty to the licensor for rights to the technology. However, royalty-based financing refers to a different type of royalty; the agreement between borrower and lender creates a new type of royalty that is based on a percentage of future revenue rather than a licensing agreement. To avoid confusion, the share of future revenue is sometimes referred to as a “revenue interest” or a “synthetic royalty.”
Royalty-based financing can be structured in many different ways. In some cases, it may be classified as equity rather than debt.
The most common structure is a term loan, with the full amount advanced up front. Payments (which include principal and interest) are based on a fixed percentage of revenue or cash receipts from the prior month or quarter.
Pros:
No minimum principal payments.
Minimal restrictive conditions.
Borrower does not have to be VC-backed.
Royalty-based financing is usually non-dilutive (i.e. the lender does not require warrants or other equity participation).
Cons:
By definition, the borrower must be generating revenue.
The business should have strong gross margins since a significant percentage of revenue will be used for loan repayments.
There is no stated interest rate so the borrower must estimate the cost using an Excel model.
Typical borrower:
Life sciences company with FDA-approved drug or medical device.
