Every once in a while, an investment model comes along that turns the innovation community on its head. An emerging paradigm called royalty-based financing — applied to early-stage start-ups — may be another, according to Gregory T. Huang of Xconomy Seattle. The concept is simple. Instead of buying equity in a young company, an investor agrees to receive a percentage of the company’s monthly revenues – but the upside is capped at a limit of, say, three to five times his or her investment. Instead of waiting five or 10 years for a start-up to go public or become acquired, an investor can start seeing returns almost immediately. The approach should enable investors to fund a wider range of start-ups than those that typically receive venture backing, Huang says. The downside is that returns are capped, so investors who back the next Google or Amazon will still recoup only five times their investment. For entrepreneurs, the model provides start-up money without giving up an ownership stake in the company.
The concept for royalty-based financing dates back to early mining days, when companies needed financing to dig for oil, natural gas, and minerals. The idea also has been used for government-funded economic development programs. It is getting renewed interest from VCs and angel investors who increasingly need quick returns in a tough climate for exits. Royalty-based venture financing “has the real potential of becoming a major new sector in the private capital market,” says Arthur Fox, the founder of Royalty Capital Management in Lexington, MA, who first used the approach with start-ups in the early 1990s. Fox tried the royalty-based idea as a way to generate compensation from companies he was mentoring, instead of taking some stock. He found that the royalty-based system made start-ups more efficient with his time, and he would get paid every month. He next tried the strategy as an investor. “It changed everything, because the normal criteria in selecting companies as a venture capitalist is a high-growth one,” Fox says. “When you invest in a company, buying stock and equity, you have no way of getting out unless they become significantly large enough to have a liquidity event.” With the royalty-based financing approach, “every month you get a check, and it doesn’t matter if they ever have an IPO or get bought out,” he says.
If you want a home run, you still need a conventional equity-based deal, Huang concedes, and that’s the main objection of most VCs to the royalty-based approach. While the model may broaden their investment options, it goes against the traditional high-risk/high-reward model. But royalty-based financing addresses the dire reality of today’s financial markets, says Thomas Thurston, the founder of Portland, OR-based Growth Science International, a research and consulting firm. “Venture capitalists say, ‘I don’t know if I’m comfortable capping [returns] at 5x,’” Thurston says. “On the other hand, you’re probably not getting 5x right now.” Thurston concludes that “there are enough circumstances where [royalty-based financing] is a good tool,” given the traditional limitations that VCs face. The approach could enable more start-ups to get off the ground and more young companies with revenues to grow, compared with the 2% of businesses that attract VC funding. Although angel investors “will be the ones who do the earliest experimentation and start to prove” the royalty-based model, Thurston thinks some intrepid VCs will try the approach as well. “I think it’ll feel less sexy to a VC,” he says. “But VCs who are innovative will say, ‘Sexy or not, I like getting good returns.’