What exactly is Royalty-based financing?
Royalty financing is a type of investment. It is sometimes referred to as revenue-based financing. Although the term itself is a hot new buzzword in venture capital, this concept has been around for a long time. It is also quite simple.
Under royalty financing, a business gets money through an investment based on future revenue. Think of it as an advance on a paycheck. The investors will earn their money back through royalties, which are a certain percentage of the revenue of the company they invested in.
Basically, instead of a traditional loan that has a fixed interest rate, investors lend money based on an agreement where the company will pay them back through royalty payments.
Types of Royalty Payments
Royalty payments are usually of two types.
- The first type is time-specific. Payments will continue under this kind of agreement for an agreed-upon amount of time. Generally, this tends to be from three to five years.
- The second type is amount-specific. Under this kind of agreement, payments will be made to an investor until they have received an agreed-upon amount of money. Typically this will be their initial investment plus 20%.
Similar to traditional loans, these types of investment agreements are considered paid in full once the terms have been met.
What Else Makes Amount-Specific Different Than Time Specific?
Amount-specific agreements are more conservative than time-specific. The amount is guaranteed, no matter how long it takes for repayment. For example, if the investor invests $100,000 and the agreement calls for their initial investment to be paid back plus 20%, then they will be paid back $120,000.
Time-specific carries more of a risk and reward structure. If a company greatly outperforms expectations, then investors can find that they get more money back than they thought they would. On the other hand, if it takes a long time for the company to grow, then investors might end up not making all the money back that they wanted to.
How it Works for Small Businesses
Part of why royalty financing has gained popularity in recent years is that it offers an alternative to traditional financing methods, such as equity financing and regular debt financing. It is also especially popular with small businesses.
Under equity financing agreements, entrepreneurs have to give up a large portion of ownership in their company to get money from outside investors. Not having to give up their equity positions can motivate the founders of a company towards continued success. It also saves them a lot of money on the legal and filing fees that are associated with equity financing and securities. Basically, royalty financing is much friendlier towards “the little guy” in the business world.
That’s not to say that this method will work for every type of small business. Usually, this financing method will only work for companies that have large revenue streams. If a company doesn’t make a lot of profits then it will have trouble repaying its investors while also covering its business expenses.
In summary, royalty-based financing is quickly becoming the investment method of choice for entrepreneurs. It can help small business owners maintain control of their companies. Although it will not work for all business types, it is a welcome alternative in many cases to traditional financing methods.