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Terralink software Systems Inc., which developed and sells a PC-based software product that helps companies manage hazardous waste information and comply with environmental laws, enjoyed a flawless launch.
In its first year, the South Portland, Maine, company generated $175,000 in sales. The second year, which ended in March 1996, saw revenues more than double, with Terralink reporting $375,000 in sales, according to founder and CEO David Fernald.
Though satisfied with the growth, Fernald had loftier goals. "My feeling was we needed to get to $750,000 in sales before repeat and referral business would really kick in," he says. "And to get to that level, we needed funds to expand our marketing efforts."
But Fernald faced the typical dilemma of early-stage companies. With Terralink still in its formative stages, investors--whether venture capitalists or angels--would want a big piece of the company. Although Fernald was comfortable with the concept of giving up equity, he was reluctant to give up big chunks early on because he anticipated there might be other financing rounds down the road.
To help devise a solution, Fernald turned to his financial advisor, Peter Moore, a principal of South Portland, Maine-based Banking Dynamics Inc., a firm that helps high-tech companies raise capital. Moore suggested Fernald consider royalty-based funding.
The royalty structure avoids equity-based complications by removing them from the picture altogether. Instead of owning a piece of the company, investors get to own a piece of the company's revenue stream.
David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in Ardmore, Pennsylvania.
Case In Point
Here's how Fernald and Moore went about raising $200,000 of investment capital to help Terralink turbocharge its sales.
Rather than tap individual investors, the two approached the Greater Portland Building Fund and Coastal Enterprises Inc., both quasi-public economic development organizations charged with developing business in the state. Instead of a loan, they sought an "advance" of $200,000 for Terralink against its future sales. If the advance was made, each of the investors would get 3 percent of Terralink's sales for 10 years, or until they received payments totaling $600,000. This $600,000 would represent the original $200,000 investment, plus $400,000 more.
In the broadest sense, for the investors to get their money back by the end of the agreed-upon time frame, Terralink would have to generate total sales of $10 million over 10 years. Fernald says the company's historical track record of doubling sales each year since inception was a big selling point. "In addition," he says, "the fact that every company in America that generates a hazardous waste stream, some 300,000 in all, are potential customers also [assured] investors that the proposed returns were achievable."
Moore says the underlying numbers provide an intriguing return as well. If Terralink repays the advance over 10 years, investors will earn a compound annual return of 11.6 percent on their investment. If, however, the company's sales mushroom and $600,000 is paid to the investors in five years, their compound annual return will increase to 24.5 percent.
The deal, which Fernald and Moore began structuring during the first quarter of 1997, closed during the summer. Moore says one of the key features of the transaction was that royalties didn't start to accrue until 90 days after the deal closed and that royalty payments to the investors didn't have to be paid until 60 days after the revenues were recognized. "There will be five months between the time Terralink received the financing and the first payment is due," says Moore, "which gives them the time they'll need to put the capital to work and start producing sales."
Way To Grow
Moore believes the royalty financing structure delivers a number of benefits to companies seeking capital:
1. Royalty financing can be easily structured with individual investors. Although Terralink secured its royalty advance from institutions, "there's no reason individual investors can't be tapped as well," says Moore. He speculates that a monthly or quarterly return--which would be generated as long as sales occur--would be more preferable to individual investors than the total absence of a yield and zero liquidity that is typical of early-stage venture deals.
2. State and federal securities laws do not apply. Because the royalty advance is essentially a loan, it is not subject to the web of regulations that affect other types of financing. In contrast, many equity financings require complex filings that generate significant legal fees and are heavily monitored by regulatory agencies.
3. Investors taste the fruits of success earlier. "In traditional private equity deals," says Moore, "the payday for the investors comes only if the company goes public or is acquired."
4. A company funded by royalty payments increases its financing ability down the road. Specifically, says Moore, if the funds help increase sales, the company becomes a more attractive candidate for additional financing. Also, sometimes the presence of one kind of equity investor precludes the participation of other kinds. For instance, a company financed with institutional venture capital funds does not, in most cases, ever go back to raising money from individuals. But by "saving" itself for a later round of financing with outside investors, a company keeps its options wide open.
5. The royalty structure preserves the equity positions of the founders. This is the most important issue for many business owners. Remember, there are only 100 percentage points to go around, and they begin to disappear with alarming ease once a company begins to raise outside capital. In addition, Moore feels that companies with founders who are able to hold on to a significant portion of ownership may be more motivated to make the company successful than entrepreneurs who have given away most of the store.
Not So Fast
Fernald says that while royalty financing is a great technique, it's not for everyone.
"It's not a good idea for companies that have very thin margins," Fernald says. After all, if your gross margin is just 10 percent, and 6 percent goes to royalty payments, then the remaining 4 percent doesn't leave much room for making any money. According to Fernald,Terralink has a gross margin of 90 percent. With margins this wide, Terralink can comfortably give up 6 percent of the sale.
In addition, Fernald suggests that royalty financings work best for companies whose pricing is fairly elastic. "If you can raise your prices to cover the lost margin and not lose any customers, you are a better candidate [for financing] than a company whose customers are price-sensitive."
Royalty financing also won't work for companies that don't see an immediate cause and effect between marketing efforts and sales, according to Moore. "You've got to be able to turn on sales like a spigot," he says. Otherwise, one of the primary benefits for which investors are in the deal--namely a monthly royalty check--becomes seriously compromised. And the one thing a growing company doesn't need is unhappy investors.
Regarding the required sales and marketing skills, Moore says the royalty financing technique may work for a company that is about to launch a product but doesn't yet have revenue. "Obviously," Moore says, "you have to be able to [convince] investors you have the skills and experience that will move products or services off the shelf quickly." But in these circumstances, Moore says, royalty investors might demand a high margin of the sale for taking on such a large risk.
Finally, Moore says royalty financing probably won't solve all a company's financing needs. But he believes it can save a company from the dilemma of giving up too much equity too early. Says Moore, "If it can do that, it's worth the consideration of any growing company looking for expansion capital."
For more information on royalty-based financing, send a business-sized self-addressed, stamped envelope to Peter Moore, Banking Dynamics, 97-A Exchange St., Portland, ME 04101.
Terralink Software Systems Inc., (207) 767-5051, firstname.lastname@example.org