Two broad categories exist in the market for business financing products: debt and equity. However, a relatively new innovation known as royalty financing combines aspects of both types of financing. Find out if royalty financing makes sense for your business.
The Big Idea Behind Royalty Financing
For ventures with significant revenues or potential investors who believe they will achieve large revenues, royalty financing may strike an interesting balance between debt and equity.
Under a royalty financing arrangement, the financier will provide a business an upfront sum of cash in exchange for a percentage of future revenues called royalty payments. You can think of royalty financing as an advance on the business’s future sales. The financier does not take an equity stake in the business.
Royalty financing tends to be more widely used when traditional financing is unavailable, such as when there is a new invention. Here, the business owner raises money from an investor, and in exchange, the investor would get a percentage of future revenues. In most cases, the investor doesn’t have a stake in the business, but they may insist on a contract that is secured by a patent or license or publishing, music, or art royalties.
How Royalty Financing Compares to Other Financing Methods
Royalty financing has characteristics in common with both debt financing and equity financing. However, it differs in several key ways from the following products.
Conventional Business Loans
Lenders typically provide business loans as either secured or unsecured term loans. These products carry either a fixed or floating interest rate and may impose covenants on the debtor. Compared to conventional business loans, royalty financing imposes a surcharge on the top-line revenue of a business.
Merchant Cash Advances
Royalty financing shares much in common with merchant cash advances (MCAs). However, while MCAs impose harsh payment terms and rigid penalties on businesses, royalty financing arrangements often allow for more flexibility in the exact cash outflows.
SBA Loans
The United States Small Business Administration offers several types of loan products, including 7(a) loans, 504 loans, and microloans. Each of these loan products focuses on a specific aspect of business financing. For instance, a 504 loan often helps businesses acquire fixed assets such as property, plant, or equipment with long-term, fixed-rate financing.
The chief difference between SBA loans and royalty financing revolves around the SBA’s requirement that business owners exhaust all other financing methods before turning to an SBA loan.
Revolver Financing
Revolver financing, such as lines of credit, provides businesses with some of the advantages of other types of revolvers, such as credit cards. However, revolver financing offers much better payment terms and interest rates for the borrower. While royalty financing acts as a source of initial cash to fund a new business or project, revolver financing often helps businesses smooth out working capital gaps during their normal operations.
Credit Cards
Business credit cards function similarly to consumer credit cards in that they provide another type of revolver financing, albeit with moderately high interest rates. Nevertheless, credit cards often act as a core component of business transactions. Royalty financing offers more flexibility and length in repayment compared to credit cards, which often require swift repayment to avoid double-digit interest charges from month to month.
Is Royalty Financing Right for Your Business?
Royalty financing offers some businesses a number of advantages, including:
- Under a royalty financing arrangement, businesses avoid giving up ownership (equity) in exchange for cash. Instead, royalty financing contracts impose a percent-of-revenue fee as compensation.
- The types of regulations that govern equity financing arrangements do not typically apply to royalty financing. This frees up legal and financial resources for businesses and financiers alike. Royalty financing provides lower risk to the business, as a royalty investment doesn’t require ownership of the business. This way, shares can be sold to raise additional funding.
- Unlike conventional term loans, royalty financing gives businesses substantial flexibility in determining when the payments begin. Financiers will often work closely with businesses to determine the best possible arrangement for both parties.
- Royalty financing does not impose restrictive covenants on businesses that take advantage of this form of funding. Many types of business loans impose both operational and financial covenants on businesses, which restrict their ability to raise more debt and can govern how businesses spend their free cash flow.
On the other hand, royalty financing may not offer an appropriate solution to businesses in the following scenarios:
- Businesses must have suitable or near-term revenues to fund the arrangement. Financiers will not cut a deal with a business that has no hope of providing substantial future revenues.
- Many conventional sources of equity financing, such as venture capital and private equity firms, will want traditional equity in the businesses and entrepreneurs in which they invest. This fact removes royalty financing as an option, especially for businesses in the technology space that are years away from profitability.
- Royalty financing arrangements do not improve the overall creditworthiness of the business. In fact, conventional lenders may not view such arrangements favorably.
Getting Started with Royalty Financing
While the royalty financing industry remains a very small portion of the overall business financing world, small funds have popped up in recent years to offer this niche product. A cursory search on your preferred search engine will review several such funds.
One example of a royalty financing fund we identified during our research bills itself as a “non-dilutive growth capital” source. This example company provides royalty financing up to $10,000,000 depending on the size of the business and other financial requirements such as strong growth rates and gross margin.
