Royalty No Dilution — Straight No Chaser

A lot of the writing about “royalty” investing is meant from the point of view of passive, public-markets investors (e.g. with oil & gas MLPs).  But when folks start looking for information about royalty with the qualifier “no dilution,” you can bet it’s in the context of a trade-off between royalty-based (or revenue-based) financing vs. equity (dilutive) financing.

So, what is it about royalty / revenue financing (RBF) that makes it non-dilutive to equity holders?

Simply put, it’s the fact that RBF trades growth capital for a part of current revenues, whereas equity trades for the residual long-term value of the business.

As a result, all things being equal, RBF is best when a company already has created a product and a strategy for selling it, but is limited as to how fast it can grow revenues with internally-generated funds under that strategy.  In effect, the RBF is funding the growth in revenue — fueling the money machine.

Contrast that with the classical case for equity, when a company is creating its product and/or its sales “machine.”  There is often substantial learning, experimenting, and iteration to be done.  In effect, the equity is funding the creation of the money machine.

Debt, too, plays a role, but is classically best when it applies to purchasing an asset with a well-understood value as collateral.  For the somewhat riskier, and more intangible, application of fueling revenue growth, RBF is (arguably) better suited.

Therefore, when a business is weighing “no dilution” RBF financing vs. the most flexible (but most dilutive and hence expensive) option of equity financing, the question should be about what the money buys.  Does it buy a variable (somewhat contingent) stake in the growth of revenues, or does it buy the residual interest in the long-term value of the company?  And, perhaps more importantly: which is the entrepreneur willing to sell?


About rlucas
Current entrepreneur and investor at RevenueLoan, doing growth financing for small businesses. Formerly with VC firm Voyager Capital in Seattle, startup Tercent, Inc. in Portland, and a variety of tomfoolery in Boston, MA (primarily skipping classes at Harvard to go down the river to MIT).

One Response to Royalty No Dilution — Straight No Chaser

  1. Pingback: Revenue-based Financing vs Equity (dilutive) financing « RevenueLoan Blog

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