Royalty financing works better with later stage companies, and it is more akin to sub-debt. In fact, at Arctaris we’re using a royalty in place of stock warrants, so there is no dilution of ownership. But when all is said and done, its use might be better suited for the company needing debt to replace the bank line it may have lost or had reduced during the recession.

It’s also a highly transparent financing structure that eliminates the black box valuation on equity that is so offensive.

The 3x-5x-10x returns mantra of Venture capital investment theory is simply naive in the current economy. The real objective, as in all investing, is the sustainable total return on capital under management. Based on VC current activity in Bio/Pharma it appears that less than 10% of deals are hitting the 10x mantra point. Investors could do just as well betting four random numbers on a roulette wheel and without management fees.

Total capital returns for the bio/pharma industry (includes un-amortized R&D investment as capital) is just under 20%/yr and falling. The foods industry is slightly higher. These are similar to the returns on capital in the leasing industry which is also similar to the expected rates of return on equity capital for RBF.

The VC industry has relied far too long on a few celebrated outlier returns realized by an even fewer number of VC celebrity investors. Using RBF to focus on capitalizing assets- which should now include intellectual property- is a far more reliable, if less glamorous way, to really serve the capital provider in new technologies.

Usually you want to at least to dream about a 10X return, even though that rarely if ever happens. It will be interesting to see if anyone tries this with Biopharma…

William- disagree with your blanket statement on R&D funding. What do R&D monies fund in the first place? Rented office/lab space, leased lab equipment, leased software- so why are you against having some R&D money fund royalties on earlier and now re-capitalized R&D? Especially if current R&D is building on a previous R&D platform.

Whole Foods doesn’t tie its money up in owning a truck fleet- it leases them so it can put the cash it saves in the groceries they transport.

Same with intellectual property, the kind of asset that R&D builds. Who wants to tie up a couple of million $ in R&D sunk costs for patents or trade secrets and then wait 12-15 years for a pay off? Sell it off now, license it back for a fair royalty and use the surplus cash to fund commercialization.

This is what savvy investors look for in successful companies. Good focus and good cash flow management. This is what RBF’s bring to the table.

Re: John Hamilton’s comments- you are dead on in recognizing that royalty financing transactions significantly broaden the scope of deals that early stage capital can invest in. Because the exit strategy is hard wired into a royalty based transaction, if offers competitive returns without speculating on the future vagaries of the public markets. Plus there are no extra exit costs compared to IPO’s. And it takes nothing away from the equity option. However as Gordon Empey previously noted, financing the intangible assets of a business first will provide significant equity valuation information which can make future equity negotiations more transparent to entrepreneur and VC alike. Whether VC’s will become averse to follow-on equity financing in existing RBF’s because of this new transparency remains to be seen.

Re: Phil Coburn’s comment- to characterize RBF’s as disguised loans misses the point that a royalty is a form of rent of specific kinds of property. In the case of most new companies this means the intangible property assets and more specifically intellectual property assets. The better analogy is capital asset leasing- like rail cars, trucking fleets and the like.

In a bona fide sale and lease back the seller-entrepreneur gets the benefit of cash on the books and a 100% write off of the lease expense as incurred. The investor gets a depreciating asset so its taxable income is offset by the periodic depreciation of the purchase price. In the RBF model,the lease becomes a license and the depreciation becomes amortization. Comparing to traditional lending, there can be over 40% in future tax savings to the entrepreneur and 40% more income to investors when measured against the initial RBF investment.

But it is also true that, depending on the investor’s use of debt, a sale leaseback of real property can be treated as a loan for accounting and tax purposes. The same is generally true for the sale and license-back of intangible assets. So, as to usury laws, it will depend on the debt and equity structure of the RBF to determine whether the transaction is a ‘true sale’ or a loan.

Finally, one comment/question for the author and commentators- It seems to me that RBF investments in selected business or technology sectors could create pools of related intellectual property rights that would be strategic to the investors and possibly to entrepreneurs. This would be in addition to the economic returns of the royalty streams of each RBF. Is the VC/ early stage investor community ready for the addition of such a paradigm?

@ Lukas – agree that many companies could face debt vs. RBF choices but high margin, high growth (but still not cfbe or debt eligible) companies could also use RBF. Equity is nearly 100% dependant upon exits, so if an equity investor doesn’t see an exit (which are increasingly rare) they don’t get in.

The real power of royalty is that it provides a way to invest in more deals. Instead of chasing the same few “gazelles” – (less than 5% of companies are appropriate for equity), royalty allows VFG to bring growth financing to a much larger segment of business in our economy – existing businesses with owners who otherwise would balk at giving up ownership/control. And royalty still offers the investor a “high touch” investment — though the nature of the partnering is based on win/win persuasion and not decision making due to lender liability issues. It also can provide the investor solid rewards, largely due to having payments start the first month (perhaps this is a good way to round out an equity portfolio with more income oriented returns). Also if you use royalty with established companies, and not start ups, there are fewer homeruns and strike outs but many more singles/doubles.

I would also point out that investors do not need to stop offering equity, but simply add royalty to the array of deal structures that you offer entrepreneurs. The result will be better for both parties, whether its royalty or equity. I don’t see royalty as disruptive – good equity deals will still get done. However when established businesses get turned down by banks and they feel like their only other choice is equity, they may feel forced into doing equity – this is a recipe for a “capital mismatch” which is bad for the entrepreneur and bad for the investor and hopefully market awareness of royalty will serve to limit that.