Startup Capital with Fewer Strings: A Look at Royalty Based Financing

by Chris Birk on 23 September 2010 0 comments

A mere whisper of the words "venture capital" or "angel investor" can inspire a shudder in some entrepreneurs.

While an infusion of capital can breathe new life into a fledgling business, there's often an equally powerful concern that accepting investment capital means ceding control of your vision.

Meet a concept that's working to carve out a middle ground: Royalty based financing.

Truth be told, it's actually an old investment method that's beginning to get a second life. But it's proving to be an increasingly attractive financing option for certain categories of small business.

The concept behind venture capitalism and angel investing is typically rooted in an exchange of equity. Entrepreneurs can lose a degree of autonomy upon bringing angels or VCs aboard, part of the give-and-take nature of these deals. On the other hand, royalty based financing forgoes the standard equity-for-cash swap and instead dishes out funding in exchange for royalty payments from your revenue stream.

The frequency and amount of those payments, and even the payment structure itself, is always up for debate and depends on the specific needs of both entrepreneur and investor. For example, you might dedicate a percentage of each month's revenue — or each quarter's revenue — as royalty payments. Some of these deals wind up resembling traditional bank loans, with fixed interest rates and routine payments, at times supplemented with a royalty check.

Royalties are capped at a certain level beyond the financier's investment. It's usually not a jaw-dropping level that triggers a new kind of shudder. There are a couple firms that specialize in royalty based financing, including Royalty Capital and Rockwater Capital.

Beth J. Felder, who this spring wrote an excellent piece on royalty based financing, breaks it down in a real-world example:

Suppose a company needs $1 million. An investor could lend the money on a 10-year repayment plan, paying only interest in the first year and equal monthly installments of principal and interest over the next nine years and, perhaps, payments of three percent of the company's monthly revenues during that same nine-year repayment period.

The investor would reap a return on principal, together with interest and the royalty amount, up to the agreed upon cap, and the company will have achieved fairly low-cost financing without giving up any equity in the company.

There's a lot to like here for entrepreneurs and investors. The financier starts see immediate returns, which isn't the standard outcome for most angel investors and venture capitalists waiting for an IPO or an acquisition. Small business owners get much-needed capital and keep a firm grasp on their original dream.

Royalty based financing doesn't make sense for every entrepreneur. Companies that aren't already experiencing some success (read: generating revenue) might have a hard time selling their story — but this can be a significant growth avenue for entrepreneurs grappling with the difficulties of raising capital in the current economic climate.

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