Royalty financing helps angels be angels

Posted by John Hamilton, VFG on Mar 20, 2018 12:03:32 PM
Businessman studies his computer screen.

Angel investors who offer royalty (also called mezzanine) financing, in addition to equity, live up to their fullest potential.

To better understand this, let’s review what angels want from their investments:

Profit

Using royalty financing, investors get their return sooner—from each month’s cash flow, as opposed to a sale or other exit years down the line.

Because the return starts the month after closing and continues each subsequent month, the Internal Rate of Return (IRR) can often match, if not exceed, that of equity investments. Royalty investments not only offer a competitive IRR, but do so at lower risk, allowing angels to balance their investment portfolios with more-income-oriented investments. This may allow angels to reduce their overall risk exposure without reducing their return.

Of course, this means due diligence in a royalty deal focuses more on the solidity of the sales pipeline than on the possibility of a future sale.

Help good companies grow

When angels have both equity and royalty financing as arrows in their quiver, they see and land more good deals.

An investor with only equity to offer looks for a “gazelle”—an early-stage start up with a large market and clear path to an exit event, or sale. By offering royalty as well, angels’ potential deals include later-stage companies, even those without a clear exit or large market. They simply have to find what every invest-able deal needs: a strong team that profitably delivers their value added product/service to the market.

Even Wall Street firms such as Goldman Sachs don’t limit themselves to private equity, and have harvested longer-term returns by offering mezzanine financing. In this way, angels are doing what they always have done—bringing Wall Street’s approach down-market to serve the needs of small, growing businesses.

Avoid dilution

Why not turn the tables on venture capital? Royalty financing may allow investors to stave off dilution for their portfolio companies, and open up a new source of deal flow from venture capitalists. With royalty in hand, you become a resource for their later-stage investments that are not quite bankable.

Vested for Growth has closed deals with a few mature venture-backed companies. In addition, royalty financing may enable angels to extend the runway for their own portfolio companies that need more capital to grow, but are avoiding a venture-capital-funded path to significant dilution.

Mentor entrepreneurs

Just like equity investors, royalty investors have the opportunity to re-live their own entrepreneurial experiences, and to “give back” by passing along their lessons learned and business contacts.

Royalty makes it easier to manage the mentoring aspect of the relationship, because the investor doesn’t have decision-making power (as a debtor, this would invite lender liability). Instead, the investor role is based on persuasion, which fits easily with the mentoring function. The royalty investor serves on the advisory board or acts as a non-voting observer on the board of directors.

Also, because there is no exit event to prepare for, the investor doesn't risk dictating either the timing or the nature of an exit that doesn’t fit the entrepreneur's interests. Therefore, it is easier to remain in a mentoring role throughout the entire life cycle of the deal.

Help the economy grow

Royalty financing allows angel investors not only to stimulate economic activity, but to improve the capital market by helping to fill the gap between bankable debt and equity. When this financing gap is unfilled, good growth plans get shelved, and good royalty deals go undone because there are not yet enough angels willing to participate.

Worse, the nature of the deals that are missed are often those that could generate the most jobs for our economy.

If you're an angel who already offers royalty financing, are there additional reasons for doing so?

If you've chosen not to use royalty, please comment on what is holding you back.

John Hamilton is Vested for Growth's Managing Director and the New Hampshire Community Loan Fund’s Vice President of Economic Opportunity.

Tags: Capital, Royalty, Mezzanine, Angels

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