Cash is king

Entrepreneur, Dec, 1997 by David R. Evanson

5. The royalty structure preserves the equity positions of the founders. This is the most important issue for many business owners. Remember, there are only 100 percentage points to go around, and they begin to disappear with alarming ease once a company begins to raise outside capital. In addition, Moore feels that companies with founders who are able to hold on to a significant portion of ownership may be more motivated to make the company successful than entrepreneurs who have given away most of the store.

* NOT SO FAST

Fernald says that while royalty financing is a great technique, it's not for everyone.

"It's not a good idea for companies that have very thin margins," Fernald says. After all, if your gross margin is just 10 percent, and 6 percent goes to royalty payments, then the remaining 4 percent doesn't leave much room for making any money. According to Fernald,Terralink has a gross margin of 90 percent. With margins this wide, Terralink can comfortably give up 6 percent of the sale.

In addition, Fernald suggests that royalty financings work best for companies whose pricing is fairly elastic. "If you can raise your prices to cover the lost margin and not lose any customers, you are a better candidate [for financing] than a company whose customers are price-sensitive."

Royalty financing also won't work for companies that don't see an immediate cause and effect between marketing efforts and sales, according to Moore. "You've got to be able to turn on sales like a spigot," he says. Otherwise, one of the primary benefits for which investors are in the deal - namely a monthly royalty check - becomes seriously compromised. And the one thing a growing company doesn't need is unhappy investors.

Regarding the required sales and marketing skills, Moore says the royalty financing technique may work for a company that is about to launch a product but doesn't yet have revenue. "Obviously," Moore says, "you have to be able to [convince] investors you have the skills and experience that will move products or services off the shelf quickly." But in these circumstances, Moore says, royalty investors might demand a high margin of the sale for taking on such a large risk.

Finally, Moore says royalty financing probably won't solve all a company's financing needs. But he believes it can save a company from the dilemma of giving up too much equity too early. Says Moore, "If it can do that, it's worth the consideration of any growing company looking for expansion capital."

For more information on royalty-based financing, send a business-sized self-addressed, stamped envelope to Peter Moore, Banking Dynamics, 97-A Exchange St., Portland, ME 04101.

David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in Ardmore, Pennsylvania.