Risk capital for hire: a guide to royalty funding

Introduction

The aim of this article is to make the case for a fresh approach to small and medium-size enterprise financing, particularly the so-called equity gap. It proposes an instrument termed royalty funding, which would enable owner-managers to hire risk capital, rather than be hired by it.

The equity gap is widely seen as one of the most intractable and complex problems facing start-up businesses and SMEs. Without long-term investment capital, enterprises essential to the health of the nation?s society and economy may never get off the ground or grow.

Important initiatives over many years, both public and private, include the establishment of a specialist institution, ICFC (now 3i), networks of private investors, venture capital and private equity firms, new share markets, loan guarantees, tax incentives and direct public finance. These have led to much progress and success, but the problem persists, exacerbated by current financial and economic difficulties.

One major factor is that the owner-managers of many SMEs, despite a need for long-term risk capital from external sources, do not wish to obtain it in the classic form of equity, because equity could dilute their formal ownership, control and independence. Thus, a lack of risk capital on suitable terms frustrates entrepreneurial ambition and can limit economic growth. Just as damaging, the search for finance can lead businesses into excessive borrowing which can destabilise them and put their owners and creditors at serious risk.

Diverse enterprises like co-operatives, mutuals and non-profits, many of which provide vital public services, also find it difficult, if not impossible, to raise risk capital through equity without diluting their ownership status and thereby their own particular ethos and character.

Dilution can be avoided if capital were to be raised by borrowing, but borrowing hardly qualifies as true risk capital: it has to be repaid on schedule, with interest, whether or not the enterprise is successful. Borrowing may also involve charging assets as security, guarantees from owners, restrictive covenants and hefty restructuring costs in the event of re-scheduling; and it may ultimately lead to insolvency.

Royalty funding

Royalty funding is a form of asset finance which would enable enterprises to raise risk capital without diluting ownership and control, or borrowing. It is grounded in the proven and familiar practice of licensing. The way it works is that investors would own assets used by the firm rather than equity in the firm. Businesses would pay to use them through a royalty on the sales revenues that they achieve. The system rewards investors through contracted royalties, while limiting their risk through the assets they own. These assets could be both tangible, like plant and machinery, and intangible, like intellectual property and brands.

Leasing is another well-known mechanism whereby assets owned by one party are used by another. The so-called turnover lease, whereby a tenant uses premises in return for a payment based on sales revenues achieved, is a classic example of a royalty fund. Another kind, the finance lease, is closely related to borrowing and is generally classified as such. Thus, in a sense, a royalty fund is to equity as a finance lease is to a loan.

Accordingly, royalty funding uses proven mechanisms as building blocks, integrating existing business models into a straightforward financing instrument based upon standard arrangements where the business, legal and taxation consequences are well known and understood.

Royalty funding addresses the general financing problem which arises when those who are the most effective owners of an enterprise are not suitable investors, for example because they lack the necessary capital or the ability to diversify their risks, by enabling the enterprise to hire the risk capital it needs. It should be accessible to any reputable enterprise which is competently run on a business-like basis, including proprietorships, partnerships, companies and diverse enterprises like mutual, co-operative and non-profit organisations. It should also be able to cover most of the core capital requirements of the enterprise, on a medium to long-term basis, and enable it to generate its own profits and reserves.

Royalty funding should stand up without any new legislation or public subsidy. It should be an entirely private arrangement between the investor and user, which should include proper incentives to encourage the user to take good care of fund assets and to meet agreed targets.

For royalty funding to work, investor interests must be properly protected with full asset-backing, with the right to reclaim control over fund assets in the event of failure by the user to perform at an agreed minimum level of sales. The investments should be self-liquidating over a period, with the prospect of gain commensurate with the risk, in a system which lends itself to a portfolio approach, so that investors can diversify their risk. Meanwhile, investors should have no ownership or management responsibilities in respect of the user enterprise.

A wider perspective

Royalty funding is risk capital for hire, rather than risk capital provided as ownership equity. This fundamental difference has far-reaching consequences: for example payment by the enterprise for the use of capital and for the assumption of risk become costs, by way of royalties, instead of a distribution of profits by way of dividend; moreover, in the event of failure, investors can recover their assets, rather than only what is left after prior claims have been settled in full.

Royalty funding could help to provide solutions to a number of problems at an individual, grass roots level: support of new enterprise; long-term capital for SMEs, and for diverse enterprises providing public services; and reducing the number and impact of bankruptcies.

Royalty funding can only realise its potential with the support of the investors and the financial institutions which exist to provide a service to enterprise and society. With such support, the enterprises which create wealth, and the entrepreneurs, managers and staff who build them, will surely respond to the challenges ahead, and fully reward the investors that back them.