Poor Richard's Junto: management science, entrepreneurship, business ownership, management

This blog dares leaders to do better. We encourage those managers with the wits to change and we exchange ideas in management science to mutual benefit and personal development. This is the place for those leaders who admonish folly and hubris and yet are devoted to continuous mental development, entrepreneurship, business ownership, & business management. As such, let this be a forum for thought leaders, CEOs, and business owners as Ben Franklin once did with the Junto and his almanac.

If two men exchange dollars; each man stands to gain a dollar. However, let these men exchange ideas, and each stands to gain a fortune.

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Friday, June 3, 2011

RPC: A New Way to Finance Your Business

Is debt or equity the only two options for capitalization or is there something else you can look into?  Debt financing, if you can even qualify for it, requires inflexible payments calculated off of historical cash flows. The bank is often the quintessential fair weathered friend when your cash flow dips and you’re up for renewal on your small business loan. Naturally this adds to the pro-cyclical nature of senior lending so, if you’re a start-up or were recently affected by the financial crisis – good luck. Equity financing on the other hand may not require payments but does require an agreement on valuation and a potential loss of control in the business.  Also, the future value of the equity is typically uncapped, associated future dividends are given up, and the investor wants ample compensation for taking on all the risks of ownership.  With equity, the more successful your business is; the more your cost of capital becomes. Is there a way to have your cake and eat it too?

Enter the RPC; short for Revenue Participation Certificate. In an RPC, a company sells an agreed upon percentage of its revenues to an investor for a lump sum. The investor in turn receives an agreed upon rate of return and principal from future royalty payments. For added investor security, the company may offer to run all revenues through a third party trust company which distributes revenues accordingly to the company and investor. It’s also not uncommon for a company to put additional collateral or IP into the trust which it then leases back for its use. Should performance go unmet; the investor receives the collateral without incident or a foreclosure process. The investor also doesn’t have to worry about irrational expenses found under a profit sharing arrangement, the ownership liability of equity, or the requirement to agree on valuation of the business. Instead, the investor creates and retains an asset much like a note that can theoretically be sold to another party.  In return, the entrepreneur has the flexibility to focus on a longterm strategic plan without investors second guessing minute monthly expenses.

So what if revenues fall and the company ends up in a short term cash crunch? An RPC does not require a fixed interest rate or payment. The royalty will decrease in line with lower revenues and the percent of revenues itself can be negotiated to go up or down based on performance. The structure is focused around a rate of return for the investor. Therefore, if the royalty drops, it will have to be paid back over a longer period of time and possibly increased when revenues recover to achieve the threshold ROI for the investor. Alternatively, if the royalty goes up with soaring revenues the investor can get a higher yield (and potentially an increased asset value of the certificate) allowing them to share in the upside. But, the business may negotiate a ceiling ROI such that, once achieved, any excess may be applied to retire the certificate early. In this way the RPC can be cash flow friendly for the business and less risky for the investor. It’s a bit of a hybrid and the concept is easy to understand and negotiate. Selling an RPC does take a knowledgeable accountant (familiar with how to carry it on the balance sheet and disclose in the footnotes) and the terms can get pretty complicated so it’s advised to seek good council as well.

Assuming traditional debt is cheaper; wouldn’t I be better off with it if I qualify?  While the rate on senior debt is often cheaper, on a risk adjusted basis, it may not be as attractive as one might think. Senior lending today typically requires a minimum of 1.25 debt service coverage, 2:1 liquidity, a UCC-1 filing, a multiple of global adjusted tangible net-worth, and an unlimited personal guarantee. That’s a lot of risk for the business owner.  In return the interest rate can be as low as 3% and up to 8% (or more) depending on the size of your company, industry, line or term, etc. As an alternative, Mezzanine debt can range from 12% to 18% and may have warrants or other uncapped kickers. The challenge with this financing is that if you didn’t qualify for senior lending, you often won’t qualify for the increased rates with mezzanine financing unless you have material growth or an acquisition lined up.  Mez debt also typically goes behind senior lending (for a lower overall blended rate) so the previously mentioned senior debt risks are still in place. An RPC’s effective cost of capital can range from 8% to 20% or more depending on loan size, company size, CAGR, years in business, collateral, etc. However, the trade off for an RPC is flexibility, dependability (no renewal worries), no loss of equity, and the potential to qualify for more capital. The downside is that banks do not offer RPCs and there’s a learning curve as a result of their comparatively newer place in the capital markets. However, the RPC is gaining in popularity and its worth looking in to for both owners and investors looking to make a win-win deal in a tough economy. 

I want to acknowledge Arthur Lipper the III who first sat me down to tell me about the RPC. 

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