Royalty Treatment

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.

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:

• Preservation of equity: Remember, there are only 100 points of ownership to go around, and they start disappearing with alarming speed when a company is selling equity at the riskiest stage of its development. "Royalty financing," counsels Fox, "enables the entrepreneur to avoid surrendering ownership and control because it is in fact a loan rather than a sale of equity." He adds that at some point a company may still have to sell equity to raise money, but by deferring the event to a point where the company is more established, you preserve your ownership position. Selling equity in an established company is less expensive than selling it in start-up companies.

• Accessibility: Truth be told, says Fox, "most companies cannot raise equity capital. They do not have a story indicating they will be large enough to orchestrate an exit strategy, such as a buyout or public offering." In the context of how angels and VCs make their returns, the diminished prospect of a big-bang exit is a death knell. Another common barrier is that entrepreneurs aren't raising enough capital to warrant the attention of serious investors. By contrast, in a royalty structure, which provides investors a return on their investment each and every month in which sales occur, the pool of likely investors is staggering in comparison to the small coterie of tight-fisted venture investors.

• Nichemanship: Fox says professional investors typically recoil from niche or obscure markets because they're not big enough to create large enough companies to satisfy their need for size and scale. "Royalty financing prizes such markets," says Fox, "because the more specialized a market, the greater the likelihood that the profit margins can easily fund a stream of royalty payments."

• Tax deductibility: Because royalty deals are structured as loans, the return to the investor represents interest, which reduces a company's net income, true, but also lessens the tax bite for profitable companies. This isn't the case for equity investments. "As a result of the tax deduction," says Fox, "the net cost of the deal is reduced substantially."

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.

Contact Source

• Royalty Capital Management Inc.
  5 Downing Rd., Lexington, MA 02421-6918, (781) 861-8490.