Revenue Participations . . .

refer to financing structures that give an investor the right to receive a percentage of company sales or revenues. Revenue participations work like royalties: The company pays the investor an agreed-upon percentage of sales and deducts the payments as a business expense. The investor shows the payment as ordinary income. Unlike royalties, however, revenue participations usually grant a percentage of all sales instead of just those on a particular product.

Sharing a percentage of revenue with an investor can accomplish some interesting results. First, the investor may become less concerned with the company maximizing earnings (profits) because he is paid based on sales. Second, management’s attention may be focused on maximizing profits by minimizing expenses, so that its projected profit margin can be realized after the participation payment is made. Third, the investor may be less concerned with controlling or participating in company affairs. He may not even require a seat on the board or audited financial statements, at least as long as he is being paid and things are running smoothly. He will, of course, expect regular payments and regular statements of sales. Fourth, the entrepreneur gives up no equity.

The terms of a revenue participation should be negotiated carefully so that it will not create a cash flow crisis. Payments should not "kick in," or be triggered, until agreed-upon levels of sales revenue are accomplished in order to ensure that the company can handle the drain on cash flow caused by the revenue participations. Revenue participations can also be made convertible or be ratcheted, so that the investor’s percentage increases or decreases according to predetermined sales levels. In all events, revenue participations should be capped so that the company’s obligations expire once the investor has obtained the return he bargained for.

Revenue participations are not common, but they do have their advocates among investors. According to Arthur Lipper III, a venture capitalist and former chairman of Venture Magazine,

One of the reasons I like to use the revenue participation certificate method of investing in private companies is that matters of management perks are then of no concern to me. The entrepreneur should be free to live well "on the company" and spend as he feels justified without fear of shareholder or profit-interest holder criticism. That’s fine as long as every week, month, or quarter I receive the agreed-upon share of revenues. I fly economy class, and I expect others spending my money to do so also if my interest (and reason for my assuming financial risk) in their activities is profit-related.

See: Equity, Structure.