Royalty financing and the capital gap

Posted by John Hamilton, VFG on Apr 25, 2018 4:38:51 PM

I want to spread the seeds of royalty financing—a powerful new deal structure for later-stage companies with healthy gross-profit margins.

Investors, entrepreneurs and community development practitioners would be better off if they were familiar enough with the benefits and trade-offs of royalty to apply it to a given business opportunity.

I’m not saying that royalty is better than equity financing. Equity is a great way to add fuel and expertise to early-stage companies, particularly when timing to market is critical to their success. I'm grateful for equity investors, and refer many good deals to angels and venture capitalists.

But few companies offer the type of “hockey stick” growth and serve large-enough markets to justify becoming equity investors’ best choices for maximizing return. Consequently, equity is appropriate for, at most, three percent of businesses.

So what are we doing for the other 97 percent?  We must answer that question if we want to grow our economy.

Royalty financing is a growth-capital solution for a business with a strong team, market, and product, but with no clear plan to sell the company (or “exit”); and for businesses looking for risk-tolerant capital to sustain long-term growth. That’s because the royalty investor is paid out of the business’s future cash flow (generally as a percentage of the future gross revenue) instead of from an exit or “cash out” event.

Royalty offers a way to get growth capital into established businesses that are coming off a tough couple of years and need more risk-tolerant capital than a bank can offer, but that aren’t ready for or attractive to equity investors. And it offers owners of later-stage companies, who resist capital that requires them to give up control or sell their businesses, a way to raise capital that is not dilutive and doesn’t require loss of control.

It is time for us investors to take the advice we often give entrepreneurs: When the market changes, you need to adapt and innovate. A Wall Street Journal article discussed how royalty financing has emerged as an alternative to traditional equity. Several angels who participated in one of Vested for Growth’s royalty investments had previously walked away from a deal with the same company. They believed in the business’s growth proposition, but  couldn't see a clear exit .

A bad equity deal may be a good royalty deal and vice versa. So why not have both tools available?

The emergence of royalty financing may also help to realize the original promise of venture capital and private equity. Peter Brooke, who became the “Johnny Appleseed of venture capital,” had a vision back in the 1960s that venture capital was not just about getting good returns on an investment, but an essential tool for economic growth and development.

At a time when some believe that venture capital’s best days are behind it, it may be helpful to be reminded that the key to Peter’s success—and his lasting legacy—was his vision for building successful businesses that create jobs and persevere through differing and difficult business cycles. More about his vision can be found in his book, A Vision for Venture Capital.

If you have misgivings, questions or comments about the use of royalty, I welcome your feedback.  I am also interested in fresh ideas about how to get  it more visibility …

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

Read about how Vested for Growth's royalty financing sets companies up for success.

Tags: Capital, Royalty, Mezzanine, Growth, Alternative lenders

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