Small Business Advice
Alternate source of funding for startups and early-stage companies
Most startups and very early-stage companies with very little financial history generally find most traditional funding sources – banks – closed to them. Many banks consider a startup anything less than two years old, so if a small business owner needs financing, it usually needs some type of non-traditional funding. One source of funding that is being seen more often are royalties, or revenue-based financing.
Royalties became common in the early 1900’s to finance oil and natural gas exploration. Owners of land where oil and gas prospectors wanted to drill gave them the rights to drill in return for a participation in the revenues or royalties. It later came to be used in industries such as music, book publishing and pharmaceuticals.
One of the primary advantages of royalty financing is that the business owner does not have to give up any equity in the company. Royalties are based totally on sales. Probably the most often seen is a straight royalty arrangement with a cap. For example, an owner might offer a percentage of revenues up to a cap of some fixed dollar amount. One might be a percentage of revenues for a fixed period of time, say a 3% royalty on sales for a period of two years; or a 3% royalty on revenues until 150% of the advance is paid back.
Another possibility is a term loan with a percentage of revenues on top. The main benefit of this type of structure is that the investor sees an exit. Venture capital investors always want to see an exit strategy; the owner either sells or goes public in three to five years.
A revenue-sharing note offers the investor an exit strategy. In today’s interest rate climate, 2% interest is more than the current rate on the 5-year U. S. Treasury note. So suppose you offer a 3-year note at 2% and a 2% royalty on revenues for three years. The investor looks at it and sees that — at least if sales are poor — there is still a note with an interest rate comparable or better than Treasuries.
The note is totally negotiable depending on the investor and the perceived risk of the deal, so the investor hopefully will at least get his/her money back. But if you are successful, the investor gets the interest on the note plus an increasing stream of revenue from the royalties. At the end of the term the investor could do extremely well with the safety of an exit.
Royalty financing offers the advantage of giving up no equity, but also, and maybe more important, if the business does well it allows time to build revenues and profits so that a traditional bank will be much more interested and accepting in the future.
Note: This is an edited version of an article written by SCORE counselor and former SBA Loan Specialist, Doug Carleton.
Gray Poehler is a volunteer with the Naples Chapter of SCORE.
A SCORE counselor since 2005, Gray Poehler owned and operated an independent insurance agency with 20 employees and two locations. He has earned the Certified Insurance Counselor designation and is familiar with both personal and commercial property and casualty insurance. Areas of expertise include: Business Finance and Accounting; Business Strategy and Planning; Business Operations; Human Resources and Internal Communications; Sales, Marketing and Public Relations.
To learn more about management issues of small businesses, contact the SCORE office nearest you.