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Royalty financing: Why adding royalty financing helps angels be angels

By John Hamilton

[April 22, 2010]

Angels who offer royalty financing in addition to equity live up to their fullest potential. To better understand this, let’s review the reasons angels invest in the first place (this list is in no particular order):  

  •  Angels invest to make money:  With royalty financing, the investor gets his or her return sooner – from  each month’s cash flow as opposed to a sale or other exit years down the line. Because the return starts the month after closing and continues each subsequent month, the Internal Rate of Return (IRR) can often match, if not exceed, that of equity investments. Royalty investments not only offer a competitive IRR, but do so at lower risk, allowing angels to balance their investment portfolios with more-income-oriented investments. This may allow angels to reduce their overall risk exposure without reducing their return.  Of course, this means that due diligence in a royalty deal focuses more on the solidity of the sales pipeline than on the possibility of a future sale.
  •  Angels want to help “good companies” grow:  When angels have both equity and royalty financing as arrows in their quiver, they see and land more “good deals.”  An investor with only equity to offer looks for a “gazelle” – an early-stage start up with a large market and clear path to an exit event, or sale. By offering royalty as well, angels’ potential deals include later-stage companies, even those without a clear exit or large market. They simply have to find what every investable deal needs: a strong team that profitably delivers their value added product/service to the market. Even Wall Street firms such as Goldman Sachs don’t limit themselves to private equity, and have harvested longer-term returns by offering mezzanine financing. In this way, angels are doing what they always have done – bringing Wall Street’s approach down-market to serve the needs of small, growing businesses.
  • Angels want to avoid getting diluted:  Why not turn the tables on venture capital? With royalty financing, you may be able to stave off dilution for your portfolio companies, and open up a new source of deal flow from venture capitalists. With royalty in hand, you become a resource for their later-stage investments that are not quite bankable. Vested for Growth has recently closed deals with a few mature venture-backed companies. In addition, the royalty financing option may enable angel investors to extend the runway for their own portfolio companies that need more capital to grow but are avoiding a venture-capital-funded path to significant dilution.
  • Angels want to mentor entrepreneurs:  Just like equity investors, royalty investors have the opportunity to re-live their own entrepreneurial experiences and to “give back” by passing along their lessons learned and business contacts. Royalty makes it easier to manage the mentoring aspect of the relationship, because the investor doesn’t have decision-making power (as a debtor, this would invite lender liability). Instead, the investor role is based on persuasion, which fits easily with the mentoring function. The royalty investor serves on the advisory board or acts as a non-voting observer on the board of directors. Also, because there is no exit event to prepare for, the investor does not risk dictating either the timing or the nature of an exit that doesn’t fit the self-interest of the entrepreneur. Therefore, it is easier to remain in a mentoring role throughout the entire life cycle of the deal. 
  • Angels want to help the economy grow: Royalty financing allows angels  not only to stimulate economic activity with their investments, but to improve  the capital market by helping to fill the gap between bankable debt and equity. When this financing gap is unfilled, good growth plans get shelved. Good royalty deals go undone because there are not yet enough angels willing to participate. Worse yet, the nature of the deals that are missed are often those with the highest potential job impact, according to a recent SBA article, and serve to generate the most jobs for our economy.

If you are an angel who already offers royalty, are there additional reasons? If you are an angel who has chosen not to add royalty, please comment on what is holding you back …

This is the second in a series of posts that explore royalty financing as a tool for angels, entrepreneurs, investors and community development practitioners.

John Hamilton is Vested for Growth‘s Managing Director and the New Hampshire Community Loan Fund’s Vice President of Economic Opportunity. More Community Loan Fund blogs.

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