Royalty Financing — Misunderstood or Mysterious?

There are three ways that a business can finance its operations and development:

  • Debt
  • Equity
  • Royalty

The first two are the most common and the easiest to understand.

Debt financing simply means borrowing money without giving up actual ownership of any assets. Often lenders will require some kind of security interest or lien against those assets, but as long as you pay your debt properly you do not give up any of your business, your assets, or your revenue.

Equity financing is the process of raising capital by selling shares or ownership interest in your business. How this actually takes place will vary according to the size and strength of the company brand and finances. An established company finds it much easier to issue shares than a start up venture. Start up ventures often have to give up majority control of their company in order to receive funding from Venture Capitalists.

So what is Royalty Financing?

Royalty Financing is often referred to as a “new concept” in investing, however, this is not really true. Royalties have been around for quite a long time. Royalties are what someone receives in exchange for allowing a business to use some kind of valuable asset, or in some cases just money. The most traditional form of royalties usually involve some form of intellectual property such as music, books, or other artistic endeavors which the artist licenses to the company in exchange for a fixed percentage of the sales. Royalties are also very common in regards to licensing of scientific properties such as patents and designs. The royalty can be compared to a sales commission, only the receiver of the royalty does not have to perform any additional tasks to receive the payment.

What is somewhat novel is the idea that investors can receive royalties from the sale of a product or service in exchange for a fixed investment that is often used to further develop the business opportunity. The most common means of royalty financing is to give the investor a fixed percentage of the revenue of the business or the revenue from the sales of a specific line of products or services.

There are many advantages to a royalty financing arrangement:

  • The most obvious advantage for the business is the fact that the company remains in control of its own destiny while facing fewer risks associated with borrowing money.
  • Easier regulatory environment. Since no shares in the company are being sold securities regulations should not apply.
  • It can also be easier to obtain royalty financing when future revenues are predictable and consistent even if other factors may be more risky.
  • Royalty financing is more flexible than equity or debt financing since the royalty payments will vary according to the revenue rather than upon some preset fixed amount. In good years royalty holders will receive higher payments, and in bad years lower payments. This gives the company the ability to better withstand the possibility of future downturns while giving the investors greater opportunities to participate in the upturns that may occur.
  • Royalty payments are usually tax deductible from the company’s gross income thus lowering the company’s tax liabilities, and also avoiding the double taxation that often occurs with dividend or profit sharing payments.
  • Because the company does not have to give up equity in order to obtain financing, the company can often focus more on operations, and less upon exit strategies of the founders and initial investors.
  • Finally, royalty payments are more secure for the investors since the payments are based upon a percentage of the gross sales or revenue rather than profits. Even if the company is unprofitable, if it makes any sales the investors will receive the benefit. It is also much more difficult to use obscure accounting methods to conceal, reduce, or eliminate a company’s gross revenues than profits.

Royalty financing is not ideal for every business. Businesses that lack predictable and consistent future revenues will find it very difficult to successfully obtain such financing. Also, royalty financing may turn out to be more expensive than equity or debt financing, even if it is more flexible for the company and more secure for the investors.

Sometimes royalty financing is misunderstood, but it is never a mystery. It is just a very convenient way for some businesses to attract financing that would otherwise be difficult or impossible to obtain otherwise.