Equity vs. Royalty: Do Royalties Affect Equity in Business?
By: Patrick Floeck
Oct 26, 2022
Access to capital can be a critical success factor when starting and growing a business. Securing outside financing could make the difference between building a wildly successful company and one that merely gets by. Capital often allows additional flexibility to invest in hiring the right people or pursuing exciting new opportunities.
But there are many options to consider when financing your business. Many go the bootstrapping route and self-fund, while others turn to debt financing and take out loans. Others might try to crowdfund or seek to trade partial ownership for a capital injection through venture financing or private equity. One less common but potentially effective business financing option is a royalties agreement.
What is a royalty in business, and is it a good financing option for your company? How does it impact your equity or ownership structure?
What is Equity Financing?
Because people often use debt in their personal finances, many are familiar with the concept of debt financing, where a company takes out a loan and pays it back over time with interest. However, equity financing is a different way for companies to raise money. Rather than borrowing money and paying it back with interest, companies sell a percentage of ownership in the company in exchange for funding.
Equity is ownership in a company. When you sell equity in your company, you exchange a portion of ownership of the company for cash, services, or other expertise. These deals can be done through private investors or by going public and selling shares on the stock market.
What Is a Royalty in Business?
Because it’s not used as often, you might not be familiar with a royalties arrangement, and when to choose royalties vs. equity might not be entirely clear.
A royalty is a payment for the use of property, usually Intellectual Property (IP). Royalty deals are standard in mining and creative fields—like music, books, and films—but investors and business owners can apply the principle to any venture. Royalty funding enables you to raise capital in exchange for a percentage of a project or product’s future revenues.
In many ways, royalty arrangements are similar to debt financing. When you agree to a royalty investment, you are committing to pay back the investment with a portion of your company’s future revenue for a specific period or until reaching a predetermined sum.
Key Differences of Equity vs. Royalty
When it comes to deciding between equity vs. royalty financing, both options carry several pros and cons.
Equity vs. royalty: Changes in ownership structure
With equity financing, you sell a portion of your company for cash. In return for the investment, some equity investors may require a significant percentage stake and a voice in company decisions. Although this may sound intimidating to first-time business founders, an unbiased party can add value that goes beyond a simple injection of capital. Many investors also bring know-how, business insight, and access to people and ideas.
A royalty financing arrangement is neither equity nor debt. With royalty investments, the borrower’s equity stake isn’t affected, and they maintain existing debt levels. Further, the business owner remains in control of the company. These factors can be attractive for the owner and future investors.
Equity doesn’t require repayment
One key advantage of equity financing is that it does not need to be repaid like a loan. Although investors are counting on a return for their investment, the company doesn’t have to worry about making regular payments or accruing interest charges.
The main downside of royalty shares is that you commit a portion of your future revenue to your investors for a predetermined period, usually limited by time or dollar amount. Perpetuity vs. royalty is slightly different in that the payment is due indefinitely and not up to a specific date or number of units sold.
Both royalties and equity deals can be expensive
You essentially sell the rights to future revenue from your product or service with royalty financing. Although you avoid giving up a percentage of direct ownership as with equity financing, royalty investors will expect the return to compensate them for the investment.
A royalty investment’s interest rate is rarely defined, and promising a portion of your future revenue can be risky. With a wildly successful product, the borrower can end up paying far more than with other types of financing arrangements.
Can choosing royalties vs. equity impact company valuation?
A royalties deal creates a contractual obligation to pay a percentage of sales to the investor. This percentage typically reduces the company’s profit margins and bottom line, which reduces the return on equity and company valuation. However, a company with easily variable pricing and a solid ability to adjust prices to absorb the negative impact will be much less affected.
Royalty vs. Equity: How to Decide Which Is Better for Your Company?
Your business’s ownership structure is just that: yours, and answering the equity vs. royalty question for your business can be challenging. You get to choose how to fund your company and who has a say in how it’s run. The main difference between royalties vs. equity is that with equity financing, you are selling a portion of your company for cash, while with royalty financing, you are selling the rights to future revenue from your product or service.
The better choice for your business depends on multiple factors, including how comfortable you are with sharing control, how much risk you’re willing to take, and what kind of relationship and guidance you expect from an investor. Ultimately, it’s up to you to decide what’s best for your company, and the answer comes down to what’s more important to you: control or future revenue.