Understanding the Basics of Royalty Financing
What is Royalty Financing
Royalty financing is the money an investor pays an entrepreneur for a marketable idea. This financing works when there is a mutual benefit to both the investor and the entrepeneur. Anticipated or expected return are the critical aspect of this type of financing.
A typical scenario in which royalty financing is that a person or a small company has a new idea, but may be lacking the resources needed to develop the idea and market it. A person or company with money may not have the idea, and may be willing to invest on the idea, rather than on an existing business. Royalty financing is fundamentally different from venture capital, because it tends to be less structured and formal.
Methods of Royality Financing
The modalities for revenue sharing are usually worked out on an individual basis. In some cases, the entrepreneur could sell the idea (or a prototype) for a one-time fixed price and wash his hands of it. In this situation, the profit or loss the investor makes on the product or idea are in no way connected to the entrepreneur.
Another type of arrangement is a fixed fee plus profit sharing agreement. This type of royalty financing occurs when a smaller fixed, amount is agreed upon as the price for the idea, after which the revenues are shared on a mutually agreed basis over a period of time.
Benefits of Royality Financing
The major advantage for the entrepreneur is that his ideas, no matter how innovative it may be, may never see the light of the day in the absence of funding. Royalty financing is a great option for someone with great business ideas. The advantage for the investor is that a good idea that is successfully marketed is a great deal, since the cost of research and development for a product is considerably less with this kind of investment.
Disadvantages of Royalty Financing
For the entrepreneur, if the product becomes a huge success, the sense of having been deprived of the right return on a great idea is sure to linger. The profit share for having been responsible for the success of a business idea is many times less than if the investment had been his alone because his earnings are now only a portion of the revenue.
From the investor’s viewpoint, the major disadvantage is that at the end of the day, investing on an idea is after all, a gamble. Even the finest looking ideas don’t necessarily become successful. More than anything else, there is absolutely no accountability on the part of the entrepreneur in the event of a failure. The investor cannot hold the entrepreneur responsible if the product does not succeed, and typically cannot get his money back.
Types of Businsses That Use Royality Financing
The best opportunities for royalty financing exist in any rapidly expanding field or field with fresh ideas, especially in the technology field. A good software product is a fit candidate for royalty financing.
In past generations, it was natural resources that allowed governments in Africa, Middle East and Latin America to make huge profits from companies that mined these resources. Today, new technologies offer the same chances. There is no limit to the number of new ideas could take off and make it to the top, with the support of good financing.
Example of Royality Financing
Royalty financing can take many forms, but here is one example. An inventor creates a new software product and obtains a patent (which is sort of like a copyright for software, obtained to guarantee that no one can take the software without permission – for more information, refer to this article explaining patents and their uses). The inventor does not have the money to produce and market the software concept, so he approaches an investor. The investor pays $100,000, and in exchange he is guaranteed 5% of all profits from the software over the next ten years. The inventor now has the cash to get his idea off the ground, and if the software is successful, the investor stands to make much more then his original $100,000 investment.
