Landing Financing Without Taking on Debt or Giving Away Equity

If you haven't heard of royalty financing, now may be the time to study up and land that startup funding you need.

The following excerpt is from Entrepreneur's book Finance Your Business. Buy it now from Amazon | Barnes & Noble | iTunes

Serial entrepreneur Aamer Sarfraz knows that raising money to launch or grow your business is painful, and says he’s invented a better way.

Sarfraz aims to bring royalty financing to entrepreneurs. Instead of compensating investors with equity, entrepreneurs raising an R round through Sarfraz’s firm Draper Oakwood Royalty Capital will pay investors back with a small percentage of their future earnings.

Related: How These 2 Offbeat Online Lenders Could Help You Land Funding

A new option for entrepreneurs

Fundraising for your business “is an ongoing miserable process,” Sarfraz says. Banks are often not set up to work with entrepreneurs, and venture capitalists have to be focused on making an aggressive return on their money. “If you take perfectly nice, perfectly decent individuals and make them a bank or credit officer, they suddenly become very difficult to work with,” he says.

Sarfraz has both raised money as an entrepreneur and invested in other startups. His goal in establishing Draper Oakwood is to make “entrepreneur-friendly” capital, he says.

Here’s how an R round works:

Loans are paid back with a 5 percent interest rate.

An R round investment made through Draper Oakwood will be paid back by the entrepreneur as a percentage of future earnings at a rate of approximately 5 percent, explains Sarfraz. A business owner only pays back the loan in months when revenue is positive. If the business isn’t making money, then Draper Oakwood doesn’t get repaid that month.

You don’t give away any equity in your company.

Unlike a venture capital investment, Draper Oakwood doesn’t take any equity from a company it invests in. You keep full ownership in your company.

Loan decisions depend entirely on your revenue.

Unlike bank debt, Draper Oakwood doesn’t require personal guarantees. Instead, the capital investment firm decides whether to invest based on a com­pany’s ability to generate revenue. That means it’s not for everyone. As appealing as an R round sounds for the right entrepreneur, it’s not a panacea for the lending market.

Related: 6 Tips for Navigating Online Lending Options

“It’s definitely interesting for the right types of companies but is not a fit for everyone,” says Ryan Feit, CEO and cofounder of SeedInvest, an equity crowdfunding platform. “The economics typically only work for companies with high gross mar­gins, and the amount a company can borrow is limited based on its existing revenue. I see it as another tool in an entrepreneur’s toolkit. It’s only a fit for a subset of companies.”

Loans are bigger than equity crowdfunding raises, with repayment multiples much lower than venture capital raises.

The benefit of an R round over crowdfunding, Sarfraz says, is that crowdfunding rounds are typically limited in size. So while equity crowdfund­ing is “great for seed businesses,” a more mature business can’t raise the tens of millions of dollars it needs to scale. Terms and conditions of each deal are negotiated on a case-by-case basis, but Sarfraz says loans range from between $5 million and $20 million, or about one-third of the annual revenue of a company. Repayment is expected between five and seven years, at between two and a half or three times the amount loaned out. By comparison, venture cap­ital investors are typically looking for about ten times a return on their investment.

You’re on your own with the money.

Whereas a venture capitalist expects that an investment in a company also buys a seat at the boardroom table, that’s not what Draper Oakwood wants. Venture capital investors promise that with their money, they’ll also bring an entrepreneur experience, connections and networking, which often ends up being an empty promise.

“Let us give you the capital you need to go run your busi­ness,” Sarfraz says. To be sure, if an entrepreneur has a question, the Draper Oakwood team will do what it can to help. Draper Oakwood launched under the wing of legendary venture capital­ist Tim Draper, who acts as a senior advisor to the company, so the firm has access to his considerable investment portfolio and network of contacts, the Draper Venture Network. But advice and guidance don’t come standard with an R round investment.

Draper Oakwood launched with about $200 million, raised primarily from private European family funds. Not only does the capital firm offer a different approach for entrepreneurs, it also offers a different approach for the investors. Where a venture capital firm makes 10 bets hoping that one will be wildly successful, Draper Oakwood makes investments in companies that are more likely to show consistent, steady growth.

“We aren’t providing them a home run. We’re providing them yield,” Sarfraz says. “It’s a different proposition to our investors than the investors in the venture capital field.”

Related: Beating the Odds and Avoiding Failure When Crowdfunding

Virtually the only qualification Draper Oakwood looks for is a company’s revenue. If a company doesn’t already have an existing revenue stream, it won’t fit the Draper Oakwood lending model. That in and of itself is a break from the VC mold. In a world where Facebook paid $1 billion for Instagram when it wasn’t generating revenue, the slow-and-steady donkeys of the business world are largely being overlooked in favor of chasing the elusive blockbuster unicorn.

“Everyone these days is after unicorns, which we think is ridiculous,” says Sarfraz. “We don’t want imaginary flying horses to invest in. We want nice, stable businesses [that] are going to generate revenue. That’s the big difference. We prefer investing in donkeys [rather] than unicorns.”

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