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When business owners look for external capital to invest in their company’s future, equity and debt financing are typically the first options that come to mind.
An equity investment involves bringing on an investor in exchange for a partial ownership stake in the company. Debt financing, such as a traditional loan from a bank, is the other standard option.
Although many aren’t aware of it, there’s another option to consider: royalty investment.
Royalty investing is a method of raising capital to take advantage of business opportunities in exchange for a specified percentage of the company’s future revenues. These opportunities could range from launching a new product to fill a market gap, purchasing a discounted asset, or simply expanding marketing efforts on existing products.
Instead of equity in exchange for the investment, royalty investors receive a percentage of the business’s future revenue. This arrangement generally continues until reaching a specified amount of revenue or a target rate of return.
There’s often a grace period before the borrower needs to start royalty payments to give the borrower more flexibility. This lag lets the funding’s impact ramp up before the payback period begins.
Historically, royalty investing is extremely common in mining and the arts industries (music, books, and films especially). Although there are industry-specific royalty funds dedicated to investing solely in the royalties business, the arrangement can be flexibly used in just about any industry.
As with any lending or investing arrangement, knowing what’s right for your business requires carefully weighing the pros and cons.
With royalty investments, the borrower’s equity stake isn’t affected, and this type of funding is not viewed as traditional debt. The business owners remain in control of the business AND maintain existing debt levels. This arrangement may be a strong motivator for the owners and keep the company attractive for later investment rounds.
Like debt, investing in royalties is often exempt from securities laws. This allows for royalty funds to provide your business with cash to quickly invest in projects or improvements without long periods of delay. Lower costs from legal fees and federal filings leave more funds to invest once the transaction is complete.
The risk to the borrower is low if the investment doesn’t result in revenue taking off, as the repayment is based on a percentage of revenue. Penalties for defaults may also be much more flexible than with traditional debt. It’s unlikely that a royalty fund would take ownership of the borrower’s business if royalty payments don’t come as expected, but always review any financing terms with a lawyer before signing an agreement.
Despite these advantages to the borrower, royalty arrangements remain attractive to royalty funds and other investors looking for consistent monthly cash flow from royalty payments.
Lenders and investors need to be compensated for the use of their capital. Part of the investor incentive in royalty funding is the higher rate of return they will receive if the borrower pays back more money or faster than expected. With a wildly successful royalty investment, the business that borrowed the funds can pay more than it would have with a traditional loan or equity arrangement.
Companies with historically solid performance will generally have an easier time securing royalty investors. However, that doesn’t mean it’s impossible for a newer company. Solid and convincing arguments can sometimes persuade a royalty fund that the younger company’s project will be successful and secure the investment.
Royalty financing deals work best when companies have good margins or flexible pricing. Because royalties come from the top line, the percentage paid to investors directly affects the profit margins.
If you don’t already have strong margins, the ability to raise prices by a few percentage points without affecting demand may be essential. A business that cannot absorb the top-line reduction needs to minimize the margin effects by directly passing the royalty amounts to the customer.
Companies with scalable sales or shorter cycles also do well with royalty funding. The impact of the investment is visible much more quickly. In this case, a royalty investment to ratchet up marketing efforts or launch a new product could bring an immediate sales increase.
Royalty funding isn’t for every business. But it could be an option to consider if your business needs capital for an opportunity and prefers an alternative to traditional debt and equity arrangements.