Royalty financing occurs when an investor thinks that an entrepreneur has a good idea for a product or when an investor helps finance a potential high-return asset and gives the firm business credit in return for a percentage of the proceeds. It is different from purchase order financing because the investor actually takes an ownership stake in the product.
What is Royalty Financing?
New technology has really opened up the market for royalty financing. Investors are always open financing new products and services. This may be just the business credit that a small business is looking for. The key that businesses have to understand is that royalty financing does not involve a business loan. Instead, an investor gives the entrepreneur or small business owner money for financing an asset they want to sell in return for a percentage of the proceeds of the sale. So, royalty financing is actually equity financing instead of debt financing. The anticipated return for the project is the key to this type of financing.Methods of Royalty Financing
There are essentially two types of royalty financing. The first has been explained above and is when an investor gives a company an advance against future profits of a product or asset in return for a part of the profits which are, in effect, a percentage of the equity of the firm.
The second method of royalty financing is for the entrepreneur to sell the product to the investor outright. Then, the profits from the product go solely to the investor.
Advantages and Disadvantages of Royalty Financing
Entrepreneurs who have great business ideas can really benefit from royalty financing. Perhaps one of the greatest financial benefits of royalty financing is that it shows up on the firm's financial statements as an off-balance sheet item known as a contingent liability. A contingent liability is one that may or may not happen. In the case of royalty financing, the liability is contingent on the firm making money.
There are three other major advantages of royalty financing. First, there are no required debt payments to make every month. Second, it does not show up on your balance sheet as debt. Third, it does not involve selling a piece of your business. Perhaps the major disadvantage of royalty financing is its cost to the business owner. It can be quite expensive because the investor in the company's product wants a good return on the money they are using to finance the product since a new product is quite a risky venture.
If you decide to pursue royalty financing to finance the production of an asset, be sure and have an attorney look over your royalty agreement.