Royalty financing is a relatively new concept that offers an alternative to regular debt financing (loans and trade credit) and equity financing (venture capital and stock sales). In a royalty financing arrangement, a small business would receive a specific amount of funds from an investor or group of investors. This money might be put toward launching a new product or expanding the company's marketing efforts. In exchange, the investors would receive a percentage of the company's future revenues over a certain period of time, up to a specific amount. The investment can be considered an "advance" to the company, and the periodic percentage payments can be considered "royalties" to the investors.
Royalty financing arrangements offer a number of advantages to small businesses. Compared to equity financing, royalty financing enables entrepreneurs to obtain capital without giving up a significant ownership position in the company to outside investors. The founders of the company are thus able to preserve their equity position, which may help motivate them toward continued success. In addition, royalty financing arrangements—since they most resemble loans—are not subject to state and federal securities laws, as some equity financing deals are. Thus the company is able to save the time and money it might otherwise devote to complex filings and legal fees. Royalty financing also increases a company's ability to structure deals with individual investors, who might be attracted to the idea of receiving a monthly or quarterly yield over the life of their investment. In contrast, equity financing arrangements often show no yield until the stock is sold.
Compared to debt financing, royalty financing provides more convenient payback terms and less severe penalties for default. In addition, the infusion of cash may help the company increase sales, which may make it a better candidate to obtain more financing later. Finally, royalty financing enables a small business to keep its options open for later financing rounds. In contrast, a company that incurs significant debt or sells a great deal of equity in its early stages may find it difficult to attract investment later.
As an example, suppose that a small business obtains an "advance" of $100,000 against future sales from individual investors or an economic development organization. In exchange, the investors would receive 3 percent of the company's total sales for a 10 year period, to a maximum of $300,000. If the company repaid the investment over 10 years, then the investors would earn a compound annual return of 11.6 percent. However, if the investors reached their maximum royalties of $300,000 in half that time, the initial investment would yield an annual return of 24.5 percent.
A small business interested in royalty financing may be able to negotiate a grace period, so that royalties will not begin to accrue for a quarter or more following the close of the deal. It may also be possible to establish a lag between the time revenues are realized by the company and the time royalties are paid to investors. This sort of arrangement can give the small business time to put the capital to work and increase sales before paying a percentage of sales as royalties. In most cases, these arrangements are acceptable to investors since they still offer a better deal than most equity financing arrangements, which only pay when the stock is sold.
In an article for Entrepreneur, David R. Evanson noted that royalty financing may tend to work best for small businesses that have some elasticity in pricing, so that they can raise prices to cover the percentage of royalties without losing customers. Royalty financing is also suitable for companies for which increased marketing efforts have an immediate impact on sales. However, royalty financing may not be a good option for companies with very tight profit margins. In summary, the capital gained through royalty financing can enable a fledgling business to launch a new product or expand its marketing efforts without having to give up too much equity in the early stages. In royalty financing, investors own a piece of the company's revenue stream rather than a piece of the company itself.
Evanson, David R. "Cash Is King: Royalty Financing Keeps Investors Happy—and Keeps Your Company in Your Own Hands." Entrepreneur. December 1997.
Evanson, David R. "Lending Over Backwards: When the Bank Says Tough, the Tough Get Going—Five Alternative Ways to Raise Capital." Success. July 1998.