Royalty Capital: A New Solution to an Old Problem

As a student at Harvard Business School, I wrote a paper questioning a basic idea: are debt and equity the best forms of capital for entrepreneurs? The answer, I concluded, was "not always." In doing so, I promoted an alternative: royalty capital. Over the last year, I've served in my personal capacity as a judge or a mentor to a number of business plan competitions - MIT 100-K, MassChallenge, Hult Prize, among others. To my surprise, many entrepreneurs had never heard of royalty capital. Watching them consistently offer away too much equity has me doubling back to the promise of my paper.

Entrepreneurs looking for capital to fund their businesses issue equity or raise debt. In a number of cases, neither is satisfactory. Raising equity involves giving away a portion of the company's ownership --- permanently. Getting debt is often impossible without hard assets or personal guarantees; when it is available, it is often prohibitively expensive. In some cases, royalty capital is a better option to both investors and entrepreneurs.

The basic idea of royalty capital is as follows: An investor provides capital in exchange for a pre-determined percentage of annual revenues (e.g., 5 - 15%) until he/she recovers a certain multiple of the original investment (e.g., 3-5x). To illustrate, consider this example: I am an investor and I invest $100 of royalty capital in a business generating $100 of revenue. The terms of the deal stipulate a 10% revenue share and a multiple goal of 3x. In the first year, I get $10 (10% of $100 of revenue). Let's say the business doubles its revenue the following year and generates $200 of revenue; I get $20 during the second year. If the business continues to double revenue every year, I get 3x my initial investment in five years for an annual return of 48%. At that point, there is no further financial relationship between the company and me.

There are many advantages to this form of capital. For an asset-light company generating $100 of revenue, trying to raise $100 of debt would have been a fool's errand. Likewise, raising $100 of equity may have been torturously expensive. With royalty capital, the entrepreneur raises significant capital to fuel growth while remaining entirely undiluted. Plus, there are non-financial advantages to boot. Under the critical eye of venture capitalists, entrepreneurs sometimes can't call their soul their own; with royalty capital, the entrepreneur-investor relationship is simple: entrepreneurs generate revenue to pay back investors, and the faster they do it, the sooner they'll get to stop doing it. The usual cocktail of battled deal terms - rights of first refusal, pay-to-play and other lingo representing failed efforts at alliteration - can be tossed in the bin.

To be clear, royalty capital has its drawbacks: it sucks cash out of the business (albeit for a limited time) and it only works with rapidly growing businesses. In the example above, if the business stagnated at $100 of revenue a year, it would take the investor 30 years to realize a 3x return, which results in a much-diminished 10% annual return. Moreover, it may not be suitable for the kind of investing strategy that venture capitalists employ. They are in the business of taking big risks to make outsized returns - a portfolio of venture capital investments can withstand a number of "zeros" because a handful of investments return 10x, 100x or even a 1000x their initial investment. Royalty capital doesn't provide that same outsized return profile.

For royalty capital to make sense, two factors must be present. First, the revenue model should be de-risked; companies in the pre-revenue stage with no immediate path to revenue just don't offer a compelling payoff profile for obvious reasons. Second, there should be a clear and direct relationship between more capital and more revenue. An early-stage Chipotle or Lululemon are great examples; early stores demonstrated the promise of their concepts. More capital would have fueled store expansion, accelerating revenue growth and thereby juicing the return profile for royalty investors.

Royalty Capital is not for everyone but if you are an entrepreneur that has a revenue-generating business that can rapidly scale by replication, I have just the right term paper for you to dust off.