Royalty
Treatment
Instead of selling ownership, sell a piece of the
revenue stream.
An often overlooked source of capital is the company's
own sales, says Arthur Fox, a longtime proponent of so-called
royalty financing and president and CEO of Lexington,
Massachusetts-based Royalty Capital Management Inc., which
manages the Royalty Capital Fund I LP.
Here's how royalty financing works: A company seeking
growth capital takes out a loan from investors to the
tune of, say, $100,000. In exchange for the loan, the
company pays the investors a percentage of its sales every
month, anywhere from 2 percent to perhaps as much as 15
percent over an indefinite time period, until the investor
has received back the original $100,000 principal, plus
perhaps another $200,000 to $400,000 of return. According
to Fox, the benefits of deploying such a funding strategy
are many. In fact, he says, "I am surprised that
royalty funding is not standard operating procedure for
entrepreneurs."
Royalty financing benefits include:
Preservation of equity: Remember, there are only
100 points of ownership to go around, and they start disappearing
with alarming speed when a company is selling equity at
the riskiest stage of its development. "Royalty financing,"
counsels Fox, "enables the entrepreneur to avoid
surrendering ownership and control because it is in fact
a loan rather than a sale of equity." He adds that
at some point a company may still have to sell equity
to raise money, but by deferring the event to a point
where the company is more established, you preserve your
ownership position. Selling equity in an established company
is less expensive than selling it in start-up companies.
Accessibility: Truth be told, says Fox, "most
companies cannot raise equity capital. They do not have
a story indicating they will be large enough to orchestrate
an exit strategy, such as a buyout or public offering."
In the context of how angels and VCs make their returns,
the diminished prospect of a big-bang exit is a death
knell. Another common barrier is that entrepreneurs aren't
raising enough capital to warrant the attention of serious
investors. By contrast, in a royalty structure, which
provides investors a return on their investment each and
every month in which sales occur, the pool of likely investors
is staggering in comparison to the small coterie of tight-fisted
venture investors.
Nichemanship: Fox says professional investors
typically recoil from niche or obscure markets because
they're not big enough to create large enough companies
to satisfy their need for size and scale. "Royalty
financing prizes such markets," says Fox, "because
the more specialized a market, the greater the likelihood
that the profit margins can easily fund a stream of royalty
payments."
Tax deductibility: Because royalty deals are structured
as loans, the return to the investor represents interest,
which reduces a company's net income, true, but also lessens
the tax bite for profitable companies. This isn’t
the case for equity investments. "As a result of
the tax deduction," says Fox, "the net cost
of the deal is reduced substantially."
Royalty financing won't work for every company. According
to Fox, the chief characteristics of a company that can
successfully raise money through royalty financing are
high gross and operating margins and the existence of
sales.
Regarding margins, at the gross level (sales less cost
of sales) the margin should be at least 50 percent, Fox
counsels. At the operating level (gross profit less selling,
general and administrative costs), the pretax margin should
not be less than 10 percent. The reason for these requirements
is that the royalty payment to investors comes right off
the top. "There has to be enough profit in the sale
so payment to investors does not seriously undermine the
performance of the company and, consequently, its ability
to generate high margin sales in the first place."
At a broader level, that generally means companies selling
commodity products are good candidates because commodities
by definition are high-volume, low-margin products and
services.
As for sales, it would be theoretically possible to entice
investors into a deal for a product that hasn't been developed
yet, but quite difficult. In fact, if you can pull off
such a feat, you are in the wrong career. Burn your business
plan immediately and get a broker's license. The fact
is, for most investors to bet on the future sale of products,
they need to see a track record. The net, net: Start-ups
need not apply.
As a final point to consider about royalty financing:
Learn well the theoretical construct of the financing
because there are few experts who will lead you through
the deal. Fox, who generally looks at companies only in
New England, says that despite the benefits it bestows
on investors and entrepreneurs alike, royalty financing
has not reached the mainstream of entrepreneurial finance.
By David R. Evanson & Art Beroff
