BY ANDREW UPDEGROVE
One year ago the Technology Law Bulletin included an article opining that the traditional venture capital community was proving to be too inflexible in its approach to software investment. We observed that many deserving software developers were being left under-funded, and many investors were missing an opportunity to reap above-market returns on their investment capital. We also state our opinion that software industry investment should most often be made directly in specific products, and not in the companies that produce these products. That article elicited strong interest from a number of developers and potential investors.
In the past year we have taken these thoughts a step further, and have developed several investment methods which permit direct investment in software products. These structures have begun to find favor in the investment community, and we have become aware of a few other groups that are beginning to explore similar approaches to software investment.
Our interest in this area results from the fact that the traditional equity investment approach is inappropriate to fund most software developers. Historically, investors have sought gradual appreciation of stock in start-up enterprises, looking for their eventual reward to be realized through a portfolio company’s going public or being acquired. However, the vast majority of software products are produced by small companies that will never go public, may never be sold, and may never have a follow-on product which is as successful as their first product offerings (a problem which even large software companies too often share).
We submit that this is a case of a glass half full and not half empty, and the structures which we have evolved accordingly capitalize on the unique attributes of software developers. Briefly, stated, these structures are based upon the sale of a royalty interest in specific products, with a warrant representing a modest equity participation added as a “sweetener.” Thus, the investor gets a direct participation in the profits of the product financed, as well as a potential for participation (through the warrant) in the overall fortunes of the developer.
The appropriateness of this structure to software derives from several aspects peculiar to the software industry: the software products produced by most small developers have comparatively short development cycles and exceptionally high gross profit margins. As a result, a royalty participation can permit a repaid return of capital to investors while leaving adequate growth funds for the developer. Moreover, since many developers require only a few hundred thousand dollars from investors to develop and/or market a product, a royalty rate and schedule can be agreed upon which results in potential returns which can be higher and much more immediate than are available in equity investments in areas such as computer hardware and biotechnology.
Payback of this type of investment can thus be quite rapid, and total return to the investor is limited only by the lifespan of the product financed (or by a cap or buy-back right negotiated by the developer and the investors). Upon any sale of a product or of the company itself, the developer may chose to make an appropriate lump sum payment roughly comparable to the present value of the royalty stream, in order to terminate the royalty.
In short, an investor can receive current returns rather than being tied through an equity investment to a company which may have successful products but never go public. The developer, on the other hand, retains virtually complete ownership of his or her company, and may be able to fund all future products from operations, or from additional royalty financings.
An additional benefit of this type of funding is that participants may dramatically reduce the risk of their investment, since they may invest on the basis of more certain information: by providing funds to a product only months away from first sale, an investor may much more accurately judge the actual size of a market, the appetite or potential customers for a product, and the likelihood of competition. Where pure expansion capital is required, risk is further reduced, since the investor can review the sales history of a product which is already in the market. In contrast, the traditional hardware or biotechnology equity-based investor must often look years ahead past multiple unknowns to gauge the likelihood of eventual profit.
By way of an example of such an investment in practice, we have recently completed a financing for a client which required funds to launch a new, fully developed product. If sales of the product meet projections, the investors anticipate seeing their initial investment back within nine months, and expect to receive four times their original investment within two and a half years. A “shadow” warrant provides the investors with a modest general interest in the future success of the company and permits the developer, which is an S corporation, to retain its tax advantaged structure (which would not have been possible had its investors made a traditional preferred stock investment).
We are aware of at least one other royalty-based investment which has recently been completed by a venture fund (albeit on a much more complicated basis), and of at least one venture capital fund (Software Conversion International), which is under formation to make royalty investments, primarily in conversions of existing software products to new platforms.
Gesmer Updegrove LLP believes that the future of software financing lies in royalty-based financing, and will continue to report in future issues on those companies and investors which pursue this avenue of investment.