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Royalty Treatment

Instead of selling ownership, sell a piece of the revenue stream.
September 1, 2001

In The Wizard of Oz, Dorothy carried with her the power to go home all along. The problem was she didn't know clicking her heels three times would do the trick.

Entrepreneurs seem to be suffering from similar oversight. A source of growth capital is often right under their noses but goes unnoticed. And as Dorothy travels across a mysterious land, entrepreneurs descend into a netherworld of venture capitalists, angel investors and investment bankers with sometimes terrifying results.

An often overlooked source of capital is the company's own sales, says Arthur Fox, a longtime proponent of so-called royalty financing and president and CEO of Lexington, Massachusetts-based Royalty Capital Management Inc., which manages the Royalty Capital Fund I LP.

of community bank executives say small businesses are essential to their continued success.

Here's how royalty financing works: A company seeking growth capital takes out a loan from investors to the tune of, say, $100,000. In exchange for the loan, the company pays the investors a percentage of its sales every month, anywhere from 2 percent to perhaps as much as 15 percent over an indefinite time period, until the investor has received back the original $100,000 principal, plus perhaps another $200,000 to $400,000 of return. According to Fox, the benefits of deploying such a funding strategy are many. In fact, he says, "I am surprised that royalty funding is not standard operating procedure for entrepreneurs."

Royalty financing benefits include:

Royalty financing won't work for every company. According to Fox, the chief characteristics of a company that can successfully raise money through royalty financing are high gross and operating margins and the existence of sales.

Regarding margins, at the gross level (sales less cost of sales) the margin should be at least 50 percent, Fox counsels. At the operating level (gross profit less selling, general and administrative costs), the pretax margin should not be less than 10 percent. The reason for these requirements is that the royalty payment to investors comes right off the top. "There has to be enough profit in the sale so payment to investors does not seriously undermine the performance of the company and, consequently, its ability to generate high margin sales in the first place." At a broader level, that generally means companies selling commodity products are good candidates because commodities by definition are high-volume, low-margin products and services.

As for sales, it would be theoretically possible to entice investors into a deal for a product that hasn't been developed yet, but quite difficult. In fact, if you can pull off such a feat, you are in the wrong career. Burn your business plan immediately and get a broker's license. The fact is, for most investors to bet on the future sale of products, they need to see a track record. The net, net: Start-ups need not apply.

As a final point to consider about royalty financing: Learn well the theoretical construct of the financing because there are few experts who will lead you through the deal. Fox, who generally looks at companies only in New England, says that despite the benefits it bestows on investors and entrepreneurs alike, royalty financing has not reached the mainstream of entrepreneurial finance. Like Dorothy, you have a long road ahead.

David R. Evanson is a principal at Gregory FCA, an investor relations firm.

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