Royalty Based Financing

Entrepreneurs in search of investment capital walk a financial tightwire.

In traditional angel investment or venture capital circles, the give-and-take is relatively clear: The entrepreneur cedes equity in exchange for much-needed capital. That can still prove a bitter pill for some small business owners, frustrated by the valuation debate or worried about losing control of their dream.

That’s why entrepreneurs should take note of an investment model beginning to pick up steam: Royalty based financing.

It’s actually a decades-old concept that’s been adapted to a more modern venture capital environment. And many entrepreneurs are finding it a refreshing change from the traditional model.

In short, it’s relatively straightforward. Investors receive a royalty — often a portion of the company’s monthly revenue — in exchange for funding. The royalty is capped to a certain limit for each month, or during the course of a calendar year, to an amount in excess of the initial investment. But not so in excess that it breaks the bank.

This scenario has a lot to offer both investors and entrepreneurs. For their part, investors can start collecting on their investment right away. It also allows them to avoid the hassle of worrying about the exit strategy for their investment — think IPO or acquisition — while still allowing them to reap financial benefits if the time comes.

Royalty based financing allows entrepreneurs to get that seed money without giving up an ownership stake. Direction and control of the start-up remains firmly in their hands.

Now, this isn’t an attractive option for every venture capitalist or angel investor. But given the economic conditions and changing climate, this model is starting to gather momentum, at least on the coasts.

Entrepreneurs who are thinking about soliciting venture capital or angel investment funding face an uphill climb — VCs dismiss about 98 percent of all investment proposals. Small business owners putting together those proposals should do their homework and hunt for some investors open to exploring royalty based financing.

East Coast firms like Royalty Capital and Rockwater Capital specialize in this funding method. But some newer outfits like GrowthPartner.com, which invests capital and marketing expertise in high-growth start-ups, are also open to royalty based arrangements.

“I think it’ll feel less sexy to a VC,” Thomas Thurston, the founder of Oregon-based Growth Science International, told Xconomy.com this October. “But to VCs who are innovative, they’ll say, ‘Sexy or not, I like getting good returns.’ Imagine being a VC, you make an investment in September, and by October you’re getting revenues.”

Image: ell brown