Royalty Financing: Everything You Need to Know
Royalty financing is a type of investment where the business gets money based on future revenue and is similar to an advance on a paycheck. 5 min read
Updated July 7, 2020:
Royalty Financing: What Is It?
Royalty financing is a type of investment where the business gets money based on future revenue. It's similar to an advance on a paycheck. The investors get their money back through royalties that are a percentage of the company's revenue.
The repayment terms and the total amount repaid are negotiated at the start of the loan. The company's income and revenue determine how long it takes to repay the loan, which in turn affects the final repayment amount. However, a cap will be placed on the repayment amount during the initial negotiations.
Royalty financing is usually used for companies with large revenue streams. Less profitable companies wouldn't be able to repay the loan plus pay their business expenses.
The concept of royalty financing began with Bart Goodwin and Ed Mello when they saw a gap in the market for this type of investment opportunity. Their company, Cypress Growth Capital, decided to take a percentage of the borrower's monthly revenue instead of the traditional equity stake.
Royalty financing was first popular in industries such as oil and gas, pharmaceuticals, film, and even mining. However, companies like Cypress Growth Capital, Barkerville, Osisko, and Grenville Strategic Royalty Corporation have expanded their investment model into new industries.
Royalty Financing Versus Debt and Equity Financing
Debt financing means getting a traditional loan in which you don't give up any ownership of your business.
Equity financing, on the other hand, requires you to give up stocks in your company to the investors. When you give up this ownership, you risk losing some control over your business and its finances.
Royalty financing is a sort of compromise between the two. Investors see greater returns than they would with a traditional loan, and companies don't have to trade equity for financing.
When deciding which type of financing is right for you, keep the following facts in mind:
- Businesses that plan on selling eventually offering an IPO are more likely to attract equity financing.
- Lines of credit or debt financing is harder to get since the financial crisis in 2008.
- Debt financing requires fixed payments which might be challenging for companies in the early stages.
- Royalty Financing is relevant to companies that work seasonally since the revenues vary greatly during the year.
- Royalty and debt payments typically are tax-deductible while equity financing doesn't affect taxes.
- Flexibility is highest for royalty financing, while equity is less flexible and debt financing is very limited.
Reasons to Consider Using Royalty Financing
The investors see a faster return with royalty financing. In some cases, they start receiving money immediately. In other cases, the business must reach a certain amount of revenue before it begins repaying the loan. Either way, investors receive their return faster than an initial public offering or other, more traditional types of loans. With these other options, it often takes longer than five years for an investor to start getting money back.
Other advantages include the following:
- Investors get their money back regardless of how well the business does.
- Royalty financing comes with a lower risk of default because the payments are much more flexible.
- If the company does default, the investors get paid back before those with a stake in the business.
- Investors are guaranteed a certain amount of profit with royalty financing.
For investees, royalty financing is attractive because it does not depend on exits or equity ownership. The business owners stay in control and don't have to bend their business plan to please the investors. Royalty financing doesn't fall under state and federal security laws, which saves time and money on complicated filings.
The following features of royalty financing also make it more flexible and less risky for businesses:
- No minimum payments
- No personal guarantees
- No fixed loan terms
- No lump sum payments
- No restrictive conditions
Although small business loans cost less, those loans can be difficult to get. Also, because the royalty payments don't show up as debt the way interest would, companies may find it easier to attract more investors if they choose royalty financing.
Reasons to Consider Not Using Royalty Financing
Since the returns are capped, there is a limit to how much an investor can profit, and repayment is sometimes slow depending on the amount of revenue the business earns. Also, royalty financing requires a hands-off approach. Investors can't interfere with the business decisions of the company or liquidate the company if they want or need to.
For investees, royalty financing can negatively impact their company's growth because a percentage of revenue goes back to the investor instead of being reinvested in the company. This type of financing can also make it harder to pay off other debt. If the company has small profit margins, it might not be able to spare the money to pay back the loan.
With royalty financing, investors typically don't make future investments into the company, but the company still has to pay back investors even if it isn't profitable. Royalty financing is a loan, and if the company can't pay back the loan, it would have to sell its assets to make those payments.
Depending on how well the product does and the terms and conditions of the loan, royalty financing can be expensive. To even get the loan, you have to talk someone into believing your product will take off and that your company will earn enough revenue to be worth the investment.
Ways Royalty Financing Is Used
Businesses need investments for a variety of reasons, and royalty financing may provide the following opportunities:
- A bridge to the next round of financing or investments
- Growth capital for business owners who want to keep control and don't want to give investors a board seat
- Preserved ownership and value for the future sale of the business
- Acquisition capital
Ways to Get Royalty Financing
Both angel investors and private equity firms can provide royalty financing. To find opportunities, take the following steps:
- Visit your Chamber of Commerce's Small Business Development Center.
- Talk to bankers, lawyers, and accountants.
- Check out the Royalty Exchange.
There are also CrowdFunding options for royalty financing:
Criteria to Get Approved
To get approved for royalty financing, you must have existing sales. Investment companies need to see potential revenue and existing customers. Products with high profit margins are also desirable.
If you need help with royalty financing, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or for companies like Google, Menlo Ventures, and Airbnb.