The term "off-balance-sheet financing" is sometimes confusing, but when interpreted literally, it begins to take on more meaning. Specifically, it refers to capital that never shows up on a company's balance sheet. For instance, issuing equity makes a mark on the shareholder's equity section of the balance sheet, while issuing debt--i.e., getting a loan--can be seen on the liabilities section of the balance sheet. But off-balance-sheet financing never shows up there, or at least doesn't ever have to.
Here's how it works. A company--say, Widget Inc.--seeking capital to develop a new product sets up a partnership as a separate entity. The partnership, perhaps called Widget Partners, then raises money and either pays Widget Inc. on a contractual basis to develop the product on behalf of the partnership or lends the money to Widget Inc. Limited partnerships are comprised of the general partner, who manages the affairs of the partnership, and the limited partners, who are investors that put money into the partnership.
The limited partnership in the Microleague financing was called Interactive Multimedia Limited Partnership. The general partner was Interactive Multimedia Inc., a company 50 percent owned by Microleague chairman Neil Swartz. The investors put a total of $212,500 into the partnership in exchange for an interest payment, which was deferred, and royalties from the sale of the products the partnership was formed to develop.
It's not unusual for the limited partnership to contract with the original company to develop the product or service. After all, the limited partnership is simply a corporate entity with no personnel or operations. In addition, this arrangement can offer the original company a significant benefit. The financing not only misses the balance sheet altogether as a liability or diluted equity, but voilà! it shows up on the income statement as fee income.
In Swartz's case, the partnership lent the funds to Microleague rather than contracting for services. Swartz says this had to do with tax considerations for the investors and the company. But even as a loan, it's still remarkable since there's hardly a bank on the face of the earth that would lend funds for development of a product to a company with no previous track record of sales.