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Royalty financing: Not your father’s equity

By John Hamilton

[April 14, 2010]

I want to spread the seeds of royalty financing—a powerful new deal structure for later-stage companies with healthy gross-profit margins. Investors, entrepreneurs and community development practitioners would be better off if they were familiar enough with the benefits and tradeoffs of royalty to apply it to a given business opportunity.

I’m not saying that royalty is better than equity financing. Equity is a great way to add fuel and expertise to early-stage companies, particularly where timing to market is critical to their success. I am grateful for equity investors and refer many good deals to angels and venture capitalists. But few companies offer the type of “hockey stick” growth and serve large-enough markets to justify becoming equity investors’ best choices for maximizing return. Consequently, equity is appropriate for, at most, three percent of businesses.

So what are we doing about the other 97 percent?  We must answer that question if we want to grow our economy.

Royalty financing is a growth-capital solution for a business with a strong team, market, and product but with no clear plan to sell the company (or “exit”); and for businesses looking for risk-tolerant capital to sustain its long-term growth. That’s because the royalty investor is paid out of the business’s future cash flow (generally as a percentage of the future gross revenue) instead of from an exit or “cash out” event.

Royalty offers a way to get growth capital into established businesses that are coming off a tough couple of years and need more risk-tolerant capital than a bank can offer, but that aren’t ready for or attractive to equity investors. And it offers owners of later-stage companies, who won’t take on capital that requires them to give up control or sell their businesses, a way to raise capital that is not dilutive and doesn’t require loss of control.

It is time for us investors to take the advice we often give entrepreneurs: When the market changes, you need to adapt and innovate. A Wall Street Journal article discussed how royalty financing has emerged as an alternative to traditional equity. Several angels who participated in Vested for Growth’s most recent royalty investment had previously walked away from a deal with the same company when they could not see a clear exit—even though they believed in the business’s growth proposition.

A bad equity deal may be a good royalty deal and vice versa. So why not have both tools available?

The emergence of royalty financing may also help to realize the original promise of venture capital and private equity. Peter Brooke, who became the “Johnny Appleseed of venture capital,” had a vision back in the 1960s that venture capital was not just about getting good returns on an investment, but an essential tool for economic growth and development.

At a time when some believe that venture capital’s best days are behind it, it may be helpful to be reminded that the key to Peter’s success—and his lasting legacy—was his vision for building successful businesses that create jobs and persevere through differing and difficult business cycles. More about his vision can be found in his book, “A Vision for Venture Capital”.

I welcome hearing your own misgivings, questions or comments regarding the use of royalty.  I am also interested in new ideas to get it more visibility…

This is the first in a series of blogs that will 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.

Community Loan Fund