San Diego Startups and Royalty Financing

Every new San Diego and California startup needs some sort of working capital to get the business up and running. The usual method is some combination of self-financing, locating venture capital or investment financing, or finding an angel investor. Another less-well-known is something called “royalty financing.” Royalty financing has been used for many years in the oil and gas industry and in the entertainment industry for startup music and film production companies. Such financing is not only used for startups, but also used for cash infusions into an existing business. Here is a quick rundown.

San Diego Startup Companies: What is Royalty Financing?

At its core, royalty financing is an investment that is paid back based on a percentage of future business revenue. One can think of it as an advance on expected future “royalties” or income. The monthly or other periodic payments are not a fixed amount, but rather are a “floating” amount based on monthly or other periodic royalty or revenue. Usually, the percentage payment is 2% to 6% of revenue. Most often, there is some “grace period” during the startup period when payments are not due.

Many royalty financing arrangements are based on a negotiated time limit, 120 months for example. Other arrangements have a cap on the amount of royalties paid. For example, if the amount invested — say $100,000 — is paid back up based on a fixed number of months, the “repayment” could be, say, $200,000 if growth is tremendous and revenue is very good. Conversely, if the repayment is capped — at say $130,000 — if growth and revenue are slow, payments might extend out to 240 months or more. The specific royalty financing arrangement will be unique to your business and growth model/projections. A talented and experienced business attorney will be needed to help provide legal advice and counsel.

San Diego Startup Companies: Advantages and Disadvantages of Royalty Financing

The main advantages of a typical royalty financing deal are these:

• Owners do not give over an ownership interest in their business
• Investment is unsecured by personal assets of the owner of the business — no personal guaranties to sign
• Investments are generally considered subordinate to other more traditional financing — this can be useful if multiple funding sources are being sought
• Royalty financing may be easier and less expensive to obtain, depending on expected growth of your new business
• Flexible periodic payments may significantly help where revenue is volatile or seasonal or otherwise not predictable

On the flipside, the main disadvantage of royalty financing is that the investor(s) generally expect a quick start to the royalty payments – usually within a year. This is why royalty financing has been used in the oil and gas, mining, and entertainment industries. For example, the oil well will be drilled within a certain number of months and will begin, thereafter, producing. Or, for example, the new theater production company will cast, rehearse, and begin selling tickets to the public within a certain number of months and will have, thereafter, revenue to begin paying back the investment. In short, businesses without a certain level of expected growth will not be good candidates for royalty financing. In addition, as discussed above, if there is no cap to the amount paid in royalties, then the cost of royalty financing could be high. Further, if profit margins are tight, the royalty payment percentage might prove very onerous. That being said, royalty financing is an option to be considered under the right circumstances.

San Diego Business Law: Contact San Diego Corporate Law

If you would like more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides a full panoply of legal services for San Diego and California businesses. Mr. Leonard has been named a “Rising Star” three years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal.  Mr. Leonard can be reached at (858) 483-9200 or via email.

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