Revenue Participation Certificate
As the name implies, the Revenue Participation Certificate gives the investor rights to the revenues of the company. It is structured as a Ňroyalty,Ó but since that may have specific legal standing, we wonŐt call it that.
Its essence says:
I will pay you X% of revenues until you get Y times your money back.
X and Y will be negotiated in the context of your business plan. X will be large enough to provide a reasonable cash flow to the investor and Y will be set based upon perceived risk. With those numbers, you will be able to do the calculations and tell the investor that based upon your plan; this deal will provide him with a particular rate of return.
First and foremost, you can avoid selling equity in your company.
Second, the deal structure, in concept, is easy to explain to potential investors and seems to be inherently ŇfairÓ to both parties.
In your discussions with the investor, the focus of the negotiation is on when he will get his return on investment, not if he will.
If the company takes longer to grow sales than the plan anticipates, the rate of return will be reduced, but it is still likely to be attractive. For example, if it takes five years to provide the return rather than the three years that was anticipated when the deal was struck, that may mean the annual rate of return might be reduced from 30% to 17%.
This structure also has the benefit of not having to establish a value for the company at the time of the investment. Since valuation is often a stumbling block for getting entrepreneurs and investors together, this structure avoids it.
ItŐs pretty straightforward in terms of administrative overhead, too (other than the accounting and tax issues for you, your company, and your investor).
If you are a start up, you are not obligated to start paying the investor until you have actual revenues.
The terms of the deal have flexibility and can be modified in the case of special needs or circumstances.
For example, you and the investor can agree to delay the commencement of payments until 6 or 12 months after closing so that you have some runway to put the investment to work before impacting your companyŐs cash flow.
It avoids a common trap that first-time entrepreneurs and unsophisticated investors often get caught in – some form of profit sharing. It may appear obvious, at first glance, that sharing the profits is the way to accommodate both sides. In my experience, this is rarely the case.
Profit is whatŐs left after your expenses. But what are your expenses, and what should they be? If you want to hire someone, your expenses will go up. Your profitability will go down. The investor will get less money. The investor may try to stop you from hiring the person in the first place.
The same circular argument can be made for all expenditures.
ThatŐs not a good situation for either of you.
An interesting phenomenon of human nature will work to the investorŐs benefit. The persistence of the payment (be it monthly or quarterly) will be an incentive for you to pay the security off as quickly as possible. With each successive payment, you will think of how you could use the money to grow your business, or to increase your income.
Early stage companies are inherently risky, so the reality is that the investor could lose all of his investment if your company fails. You should not be surprised if the investor wants some form of security for his investment to reflect this reality.
This may not be a wise structure for a start up. Until revenues exist and thereŐs some confidence in their predictability, both sides may be deluding themselves.
The way a company generates revenues may change. For example, a software company may shift its pricing strategy from a license (one-time, large revenue) to a subscription (recurring lower revenues).
Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of this series of articles can be found at my website.