Patient capital | Advocates of royalty-based investment say it can work for a lot of small businesses. But can it get the attention of the equity crowd?

From their office overlooking Monument Square in Portland, Peter Moore and his business partner, Peter Ventre, share a dream of developing a new way for investors to put risk capital into growing companies.

The method is called royalty-based financing, where investors earn a royalty ˆ— a fixed percentage ˆ— of a company's revenue stream rather than receiving equity in the company. "It's pay as you go, pay more as you grow," Moore says. "You pay less when sales are down, more when sales are up."

The concept of royalty-based financing has been around since the 1930s. It's been used extensively by the movie, record and book-publishing industries, where royalty payments are tied to the concepts of intellectual property and copyright. But Moore and Ventre want to bring royalty financing to Main Street businesses here in Maine. "A lot of startups hit a wall," Moore says. "They realize they need one more push to get to the next plateau before there's a predictable cash flow. Royalty-based financing gives a company the ability to scale up into a bigger enterprise and expand their sales."

Moore credits Arthur Fox, president of Massachusetts-based Royalty Capital Management Inc., as the visionary behind contemporary royalty-based financing. The model, according to Fox, "fits a much broader range of companies in Maine, where there are rapidly growing tech companies and a lot of very ordinary companies," he says. Royalty funding is also an intriguing type of risk capital for entrepreneurs who want to hold on to their companies and control what happens to them.

Those goals, Fox says, sync with the royalty approach, where investors are "happy if entrepreneurs want to continue running the company. All we care about is that they sell their products and we collect royalties. They can grow slowly, spend time with their kids. There's a wider range of acceptable strategies that the royalty approach can support."

Simple in nature
When David Fernald needed $200,000 to grow Terralink, his Portland-based hazardous-waste software management company, he opted for royalty-based financing. It was 1997, the tech sector was booming, and there was ample capital available from venture and angel investors. But doing business with the traditional equity-based money sources meant sharing ownership in Terralink. While he says he's comfortable with the idea of equity financing, Fernald admits that in the early stages of Terralink's growth such financing was a step he was reluctant to take.

Instead, he turned to Moore, then principal of Banking Dynamics, a predecessor of Rockwater Capital, who brokered a royalty deal for Terralink with The Greater Portland Building Fund and Coastal Enterprises Inc. "It's easy to deal with, simple in nature," Fernald says of the arrangement. "It's working capital for companies like ours with high gross margins. It's patient capital."

In August of 2001, Moore and Ventre launched a new company, Rockwater Capital Management, and set out to create a royalty-based fund called the Rockwater Capital Fund, the second royalty fund in the country ˆ— an earlier version of Fox's fund was the first. Their plan was to make royalty investments throughout the Northeast; then came 9/11. "It devastated everything," Moore says of the impact on the nation's investment markets. "The whole country was practically paralyzed."

Combined with the dot-com bust and investors' lack of experience with royalty financing, Moore and Ventre were only able to raise a third of their $20 million goal. "For almost a year, we did fundraising," Moore says. "In 2002, we made over 200 presentations. People weren't ready." Last year, Moore and Ventre decided to put the fund on hold and focus on working with individual investors. Even though they've scaled back their dream in the face of recession and the economy-damping effects of terrorism, they say the vision of royalty-based investing remains compelling. (The pair also arranges commercial real estate financing as well as other forms of financing for private companies.)

Finding companies with potential is the critical first step. Since 1996, Moore has organized the Maine Investment Exchange, commonly called "MIX forums," for Portland-based Maine & Co. Four times a year he brings investors and entrepreneurs together in an effort to help stimulate business growth and investment in the state. He says he's seen a lot of good companies that need capital to grow but that don't have the qualities equity capitalists are looking for ˆ— high-growth companies that can be sold within three to five years to provide a return on the investment. Royalty-based financing is a perfect investment tool for some of those companies, he says.

Moore says he and Ventre look for companies in the "opportunity gap" ˆ— companies that need more than the $20,000-$100,000 that angels usually invest but less than the $3 million-$5 million minimum investment the venture crowd insists upon. Because of that gap, Moore says, "We're faced with a phenomenon of companies having to grow organically from within." It's where royalty-based financing can work for both a company and an investor.

In equity investing, the investor takes equity in the company and earns a return on his or her investment through an exit, typically a future round of equity financing, the sale of the company or, in rare instances, through an IPO. "If you can't provide an exit strategy," Moore asks, "how do you pay back capital providers? When you have a compelling business but it doesn't meet the scale-potential of the venture crowd, where does the capital come from?"

Fox, who's been making royalty investments since the early 1990's, says the idea is simple. "You give a company money, and they give you a fixed percentage of their gross cash receipts on a monthly basis." Fox's version of royalty-based financing differs from that used by the entertainment industry, where the royalty is typically paid until the property passes into the public domain. "I put a dollar cap on the total amount paid," he says, "typically five times the investment over five to eight years."

Fox started the nation's first royalty-based fund, Royalty Capital Fund, in 1992 with his business partner, John Trombley, and a half-million dollars of their own capital. "We wanted to take the concept and experiment with our own money," Fox says. "We invested in two companies, and the results within one year were very good." Fox and Trombley launched a second fund in 1994, which included 26 partners and $2.6 million of pledged capital. "Investors got three times their capital back," he says.

"Venture capitalists and angel investors look for the same thing because they're investing in equity," Fox adds. "They're looking for a high sales potential company, and hope that they grow and become significantly bigger, becoming an attractive acquisition for another buyer." For venture firms, Fox says that means looking for companies that can achieve sales of $50 million-$100 million a year ˆ— not exactly the scale of many startups in Maine. "Only a few companies will ever be successful on that scale. Most companies are successful on a more modest scale, like $15 million-$20 million, yet they're locked out of the capital market."

Tapping the revenue stream
Moore says royalty-based financing is typically expansion-stage capital, though it's also useful as a substitute for mezzanine financing and intra-family owned acquisition, where a business is passed from one family member to another. Because it's based on the company's revenue stream, the repayment is elastic, able to stretch or shrink as a company's revenue stream changes.

But it's not for everyone. "We like companies with high knowledge content and gross margins above 50%, a margin that's sustainable as the company grows," Moore says. "We look for companies with an experienced sales force that has the ability to scale up into a bigger enterprise, companies where a lot of the capital would be used to hire key sales people and go from regional sales to multi-regional, national or international sales. We like to see high cause and effect between the investment dollars and sales dollars. We want a company that's got a good core management team with ownership incentive in the company, and we favor companies that stress innovation. We avoid cyclical industries."

Fox says royalty-based investment holds significant benefits for companies. "This adapts to the business conditions a company faces at a critical point," he says. "If you borrowed, it would be a fixed cost each month to pay to a commercial lender; [repayment] is not connected to money you collected. This structure is safer for a company than debt of the ordinary type."

Royalty financing is also less intrusive than equity investment, he says, which is a key issue that discourages many entrepreneurs from seeking investment. "When an owner takes an equity partner, an angel or venture capital partner, there's a divergence of agendas that happens almost immediately," Fox points out. "The investors are interested in growing quickly and getting their cash out. Is that good for you? Good for your company? There's pressure to perform in a way to fulfill their objective of getting in and out, and they don't care about you after they're out. It's a dynamic of divergent interests."

For many businesses, the royalty percentage can be added on to the product's price. The repayment, because it's debt service, is also deductible from a company's corporate income taxes. That's how Fernald made it work at Terralink. "Usually the royalty stream becomes part of the manufacturing costs, so it's not punitive," he says. "The down side is that it's debt."

One of the major attractions for investors is receiving an almost immediate return in the form of royalty payments instead of having to wait for a so-called liquidity event, like the sale of the business. The better a company does, at least in theory, the bigger the payments to the investor. "It's ideal for investors who want to be in a higher-yielding investment, but are uncomfortable with the unknown-someday return strategy [of equity investment]," Moore says.

Typically, Moore says investors will see returns of 18%-25%, depending on how quickly a company's sales grow. He also stresses that royalty investment through a fund is good for institutional investors. "It's a good investment opportunity for smaller pension funds that can't participate at the minimum capital requirements that big venture capital wants. It's a superior risk-adjusted return, an alternative investment with current clash flow and a longer time horizon."

But there's still risk. If a company tanks, investors lose money. "In most deals we do, we will take a security interest in cooperate assets," Moore says. "We will be subordinate to a bank if the company applies to get bank funding. Usually, we have a covenant governing the amount of leverage a company has with its assets. If a company fails, investors get some recovery. Not all, but some."

A royal future?
Since putting the Rockwater Capital Fund on hold, Moore and Ventre are again performing due diligence on a number of companies, looking to match them to investors. And they say that due diligence is every bit as intense and strenuous as that done by angel and venture investors. Moore and Ventre says they're looking at a medical care products manufacturing company, a distributor of specialty women's medical care products, a maker of non-toxic wood treatment products, a wastewater treatment products/technology company and a composite products maker, among others.

Both Moore and Fox would like to see other royalty-based funds established throughout the country. As Fox points out, investment is typically a group activity, where the due diligence is shared among groups of investors. Asked why there isn't more royalty investing going on, Fox replies, "There aren't that many people that understand it. It's a new idea, and it takes time for new ideas to grow." Fox says he's currently working with other people interested in launching funds. "My intent is to help others start pools in other parts of the country, but it may be another 10 years [before that happens]," he says. "Conventional equity ˆ— venture capital ˆ— was itself a novelty if you go back as far as the end of the Second World War. Now there are hundreds of funds."

With the economy recovering, Moore says he and Ventre plan on reactivating their fund later this year, though with a scaled-down goal of about $5 million. For now, they're trying to bring royalty-based financing to the streets one investor, and one business, at a time. "It's a hybrid in an industry that doesn't like hybrids," Moore says of the royalty model. "We have to work to break the mold a bit."