Info-Age Companies Shun Debt and Equity, Embrace Royalties
BY Jerry Useem
Here's a look at a financing program based on a royalty-based plan.
When Tom Cavanaugh set out to build his T-shirt business, Copper Monkey Trading Co., he wanted everything about it to be virtual. As the lone salaried employee, he worked out of a two-room office in Duxbury, Mass., using an IBM computer to communicate with a network of 150 commission-based sales representatives. There was just one problem: lack of capital.
The very absence of fixed assets that kept his overhead so wonderfully low ($11,000 a month) made him an intensely unappealing loan candidate for banks, which tend to appreciate something tangible--machines, buildings--to back debts. Enter Royalty Capital Fund, a Lexington, Mass., company founded in 1993 by former entrepreneurs John Trombly and Arthur Fox. They didn't care a wit about Cavanaugh's assets--just his potential for sales--and they forked over $100,000. Why? The financing that Royalty Capital offers is based neither on debt nor on equity but on royalties: it purchases the right to a percentage of a company's receipts.
With the information age denuding many companies' balance sheets of tangible assets, royalty financing may be a form of funding whose time has come. Joe Fullop, chairman of the National Association of Royalty Dealers and Consultants, estimates that there are now some 200 practitioners of the method nationwide, compared with about 5 at the decade's beginning.
Here's how it works: Royalty Capital invests anywhere from $75,000 to $300,000 in a company. Trombly and Fox determine the exact royalty rate by dividing the size of their investment by the company's projected cash receipts for the first 14 months. Then, every time the company receives payment for a sale, it sends from 5% to 15% (or more) of the cash to Royalty Capital--until the fund has been paid back fivefold, including the return of capital. Trombly says that should take five years, on average.
Among the advantages: The self-adjusting payment terms (slower sales equal slower payments) don't increase the risk of insolvency the way the fixed obligation of a bank loan can. Unlike equity deals, royalty financing allows owners to retain full control of the company. And the method is well suited for companies that hold little promise of going public and therefore little possibility of attracting conventional venture capital.
Not that royalty financing is a panacea. For one thing, says Trombly, "the capital is meant to be used for activities that leverage revenues quickly, like sales and marketing--not R&D." Second, with royalties eating up, say, 10% of your receipts, low-margin businesses need not apply.