CREATIVE FINANCING

By: Bruce J. Blechman

ROYAL TREATMENT

How would you like to get money for your business without having a legal obligation to pay it back or give up any equity in your company? How would you like to add this money to your company's balance sheet as a direct increase in your net worth without increasing your liabilities? Even better, how would you like the people who gave you the money to wait around until you can afford to pay them back? Sound too good to be true? Well, it is true - it's called "royalty financing."

Most people are aware of the traditional types of financing-debt (loans) and equity (investments). If you borrow the money in the form of a loan, you are legally obligated to pay it back. You must make monthly payments of the principal and interest regardless of your business' situation. In other words, whether' business is good or bad you still must comply with the obligations of your loan. When you get the loan, the cash is added to the asset side of your balance and the loan becomes an increase in your liabilities. On the other hand, if you receive an investment, it means you have given up a percentage of your company for money. Selling a piece of your business wouldn't be so bad if you could get a proper evaluation of your company. But when it comes to smaller, privately held companies, the valuation given by investors is often low. Therefore, when a small business uses equity financing, it ends up giving away a large percentage of the ownership.

Royalty financing is completely different. It is off-balance-sheet financing because it appears on your financial statements only as a footnote -showing a contingent liability (a liability that may or may not happen). In this case, contingent upon the company making money. It's perfectly tailored to the needs of a young business and is an excellent way for entrepreneurial companies to attract investors.

HOW IT WORKS

 Royalty financing involves giving an investor a percentage of sales or gross profits instead of monthly debt payments or equity ownership in the business.  Here's how it works. Let's say you want to introduce a new product line, but lack the capital necessary for production and marketing. Instead of offering to pay back a loan to your investors or giving away a percentage of your business in return for capital, you offer your investors a percentage of the gross profits, or a royalty, from this new product line. The investors are not investing in your whole company, or even in your old product line, making it ideal for the introduction of the new line. The royalty income the investors receive is tied directly to the success of this product, and they will expect to get all their money back, plus a good return, from the sales of the new line.

 Compare this with the standard method of obtaining a bank loan for a new product line. Assume that, as in all new product introductions, sales will go up and down before straightening out to a growth curve. If you take out a bank loan, monthly payments of principal and interest must be paid no matter what happens to the economy, your industry, your company, or sales of your new product line. If sales start dropping for any reason, the bank might decide to put you out of business if the loan is not paid on time.

 Under royalty financing, however, your payments are directly related to what happens to the economy, your industry, your company, and, of course, the sales of your new product line. Because the royalty is usually a fixed percentage of sales, the royalty payments decrease - if sales decrease. If sales go up, royalty payments increase. In other words, royalty financing gives you much more flexibility than a typical bank loan. Also, with royalty financing, payments usually don't start until sales of the new product line are made. So, if you are delayed in introducing your new line you still have enough capital to get you through the tough times. What's more, under a royalty financing agreement, the revenue percentage, the term, and the exit clause are all negotiable. Try negotiating those terms with a bank!

Royalty financing is a win-win deal, offering just as many benefits to the financing source or investor as to the entrepreneur seeking capital. Here are the main advantages:

1. No specific payment schedule to meet every month, as with a loan.
2. Does not show up as debt on your balance sheet.
3. Does not dilute company ownership.
4. The investment goes directly into increasing the net worth of the company.
5. All payments to investors are tax-deductible.
6. Payments are not fixed, but tied to the revenue stream of the investment.
7. Investments can be tied directly to particular situations such as new product line introductions or other types of business expansion.
8. Does not require collateral or liens on any assets.
9. Improves your company's credit. Since the financing is off the balance sheet, you can borrow more money from conventional lenders.

Here are some advantages royalty financing offers the investor:

1. Investors get their money directly from the revenue stream before any other creditors are paid, and even before the company's owners are paid.
2. Investors do not have to pay double taxation on getting their money back in the form of dividends.
3. The return on investment can be far greater than a normal stock purchase in the same company.
4. Investors do not have to wait for the company to issue dividends, go public, sell out to another company, or experience tremendous sales growth before they get a return on their investment.
5. Royalty financing eliminates the problem of minority stockholders being dependent on the mere whim of the majority stockholders to get a return on their investment.
6. The investments is fixed to a percentage of sales and cannot be changed without mutual consent.

WHAT YOU SHOULD KNOW

 Royalty financing's only major disadvantage is its cost. Investors usually want a higher return than you would pay a bank. That means royalty financing is not for every company. A well-established company in mature industry would probably do better with a bank loan. Rut, in today's economy, how many companies qualify as being well-established and mature?

 If you think royalty financing is for you, here are some points to consider when setting up such a program. First, think through all aspects of the royalty program before you -sign on the dotted line. Make sure you can stop or reduce the payments once the investors have received an excellent return. Although royalty payments could theoretically go on forever, you should set an agreed-upon cap or point of diminishing return. - Insist on an exit clause that allows your company to extricate itself from paying royalties at some point. If your product line turns out to be a best-seller, you don't want the investors to take all the profits-merely a healthy return on their investment.

 One way to do this is to arrange to buy out the investors' royalty payments at a predetermined price. Some companies even offer equity instead of cash to buy out royalty investors. For example, instead of paying the investors cash, you might affect your profitability. You don't want to be tied to a royalty financing deal that forces you to make payments based on outdated cost figures.

 Third, don't attempt royalty financing unless you can raise your prices enough to give you some profit after the royalties are paid. - You don't want the royalty payments to eat up all your profits. As a rule of thumb, you should be able to raise the prices you charge for your products or services by at least as much as the royalty fee.

 Royalty financing is just one technique in any aggressive investment banker's bag of tricks. If you are looking for a small amount of money-typically less than $100,00 you can probably negotiate a royalty financing arrangement with an investor on your own. However, if you go this route, have an attorney go over the agreement before you sign on the dotted line. If you are looking for more than $100,000 you should look for an investor through your investment banker, financing consultant or securities lawyer, or write to me in care of Entrepreneur for the names of firms that specialize in royalty financing.

Back to Articles