Royalty Financing: Another Creative Way For Start Up Financing
In today’s world, a frozen credit market and dried up funding channels have made it nearly impossible to start a business. However, there are still some creative ways to secure funding for your venture. Royalty financing is a unique funding option that has long been used in entertainment deals. This type of financing is gaining popularity in other types of business ventures. Below are the details and possible downsides of Royalty Financing.
Background of Royalty Financing
When trying to start a new business, entrepreneurs often choose between two funding options: venture capitalists or angel investors. These financing sources require quite a bit of already established equity, as well as large returns.
Royalty financing provides a third option, most often used in entertainment and mining-related ventures.
What is Royalty Financing?
Royalty financing refers to a company paying back a loan using a percentage of their revenue.
The terms and conditions of Royalty financing when used in technology and business can differ. Most arrangements include a version of the following terms:
Royalty Financing Definition
Royalty financing simply means a company paying back the loan using some percentage of its revenue.
Royalty Financing Terms Differ
The terms and condition of royalty financing arrangements in technology and other potential-growth companies, aside from entertainment and mining, usually differ. Often such arrangements have some variation of the following:
- Raising funds from institutional investors with some specified amortized loan payment schedule for 5-10 years.
- Raising funds from institutional investors with some amortized loan payment schedule AND stock warrant as a safeguard, if the company’s stock appreciably appreciates in value.
- An agreement to pay some kind of incremental revenue ranging from 2%-6% over a specified time period OR until a negotiated multiple of the investment is paid back. The latter strategy is extremely prudent especially when the company does not intend to pay more than a specified sum.
Possible Downsides of Royalty Financing
Royalty Financing may be difficult to secure. Many companies are not candidates for Royalty Financing because they lack the growth potential. Royalty Financing hinges on the principle that the company will be profitable in a short period of time. It is not uncommon for start-ups and new business to lose money for the first few years before becoming profitable and this would disqualify them from Royalty Financing.
Royalty Financing can be expensive and burdensome. The structure of royalty payments could add up to exceed the cost of a bank loan if built up over the long term. A business would be wise to negotiate a royalty cap.
