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A New Deal

Royalty financing as a means of paying back investors through royalties on product sales.
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Paying back investors through royalties won't hurt your company'spocketbook, shareholders, or balance sheet

Ah, cash. That most beautiful thing in a business. However it comes to you, in whatever form, you welcome it with open arms -- especially in these capital-scarce days. And yet, few forms of capital are tailored to a young business's needs. A bank loan is great -- while you're getting the money. But you have to begin paying hefty interest charges right away, whether you can afford to or not. And although you don't have to pay back equity capital, you do pay a heavy price: giving up ownership.

Meet the new kid on the block: royalty financing. In this type of arrangement, capital is repaid through a stream of royalties on product sales. It provides a way for a company to get money in the door without having to send any out again until the business can afford it. Royalty financing won't ring any bells among the pin-striped set. It's too rare to be called a trend. But it makes so much sense that any company talking to potential investors should consider it.

Jim Anderson didn't have the luxury of mulling over a range of options when he was looking for capital for Applied Intelligent Systems Inc. (AISI), a $4-million maker of machine vision systems in Ann Arbor, Mich. Once the darling of venture capitalists, his industry had become poison to investors by the late 1980s, after dozens of machine vision companies performed poorly or failed altogether. AISI had been able to land several infusions of venture capital throughout the early '80s, but by the time Anderson went hunting for money to launch the company's third product, in 1987, "it was career suicide for a venture capitalist to throw money into our industry," says Anderson.

Luckily, Tom Nastas, the president of Innovative Ventures Inc. and the managing partner of the Michigan Product Development Fund, didn't share that view. Nastas had devised a nontraditional financing technique that can foster growth without handicapping a company's ability to retain earnings and without diluting its ownership. The structure was simple. The fund makes an investment that entitles it to a portion of a company's revenue stream. Over time, those slices of revenue -- royalties -- allow Innovative Ventures to recoup its investment and earn a healthy return.

Anderson's need for capital fit that structure perfectly. AISI had just finished designing a prototype of a new vision system -- the AIS-3000. To bring the product to market, however, the company needed $700,000 to build inventory, hire salespeople, print brochures, and pay for other marketing activities. After Anderson contacted Innovative Ventures, Nastas and his staff did an exhaustive analysis of AISI and required the company to rework its marketing plan before committing any capital. Here's how the three components of AISI's royalty financing worked:

* The investment. Nastas had the fund dole out the $700,000 investment in thirds, after AISI met certain preset conditions. To get the first $233,333, AISI had to turn the prototype product into a preproduction model that demonstrably worked. The second sum could be collected when AISI began production, and the final disbursement would arrive when the company began shipping the AIS-3000. At every stage, AISI had to account for all its expenditures and was subject to audits by Innovative Ventures. Although the fund didn't have a seat on AISI's board, Anderson found it easiest to include Nastas in board and other company meetings so Nastas could gather all the information that Innovative Ventures required. In all, the investment period took about six months.

* Paying royalties. AISI arranged to pay Innovative Ventures its cut for the life of the AIS-3000. As it turned out, the AIS-3000 sold very well from the start, when an important customer, Universal Instruments Corp., began placing large orders. AISI paid the royalty -- of about 5% -- on a quarterly basis.

Innovative Ventures had negotiated its cut of sales on the basis of a number of factors. Key among them: the 25% rate of return that the fund required, the expected five-year life span of the AIS-3000, and the sales projections for the AIS-3000 -- more than $30 million over that five-year period. AISI would, of course, pay the royalty beyond the five-year period if the product's sales continued. In case AISI needed to extricate itself from the arrangement, Anderson also negotiated an exit clause. AISI could buy out Innovative Ventures at any time for $1 million.

* The conversion. As time went by, something unexpected happened. The AIS-3000 became a star. Its sales were growing faster than overall sales at the company, and it looked as though the product would outlive its five-year life span.

"We took a look at what had been paid in to Innovative Ventures, and we realized what the payback might be over the whole time period," recalls Anderson. It would likely have been a huge amount -- way beyond everyone's expectation. He wanted to stop the royalty payments, but he didn't have the $1 million to buy Innovative Ventures out.

Instead of borrowing the money to pay off Innovative Ventures, Anderson elected to pay with equity in AISI -- an option that a more possessive business owner might have eschewed. Using the valuation of AISI's stock during the company's most recent round of equity financing, Anderson translated the $1 million into a 10% stake for Innovative Ventures.

There were two key ingredients that made royalty financing so workable for Anderson. The first, of course, was the timing of the repayment. It's rare that the people you owe money to will wait until you have it in hand. That's the chief beauty of this financing arrangement. But it's not necessarily the best solution, unless you have the second ingredient: pricing flexibility. A royalty is just going to eat into your profit margin unless you are able to raise the price you charge for your product by at least as much as the royalty fee.

Nastas, a royalty-financing enthusiast, points out that this kind of structure could make some difficult-to-finance companies, such as service operations or medium-growth businesses, more attractive to investors. Royalty financing doesn't require that a company have a lot of assets available for collateral, for example. Nor does it require enormous sales growth before an investor can achieve a return.

What's more, it has a benefit that isn't fully apparent until a royalty-financed company moves on to seeking its next capital infusion. With such financing, Nastas explains, "you're improving your capital structure because all of a sudden you've got more money to work with but no new liability on the balance sheet."


THE ROYAL TREATMENT

Advantages of the Deal

Royalty financing is essentially the provision of capital in exchange for a percentage of a revenue stream. The actual royalty percentage, the term, and the exit clause are all negotiable. These are some of the advantages that this kind of structure has over conventional equity investments and loans:

* No dilution. The ownership of the company remains the same unless you decide you want to create a conversion feature and sell the revenue stream for equity or attach stock warrants to your agreement.

* Great timing. Payments to investors are not required until you start making sales.

* Invisibility. No liability shows up on the balance sheet.

* Flexibility. You can use this structure to finance a specific product or your entire company.




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