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Royalty Funding: A Solution for the Equity Gap?

This entry describes the case for a fresh approach to enterprise financing, particularly the so-called equity gap. It proposes an instrument called royalty funding, which would enable effective owners and managers to hire risk capital, rather than be hired by it.

The equity gap is widely seen as one of the most intractable financing problems facing the start-up business and the small and medium-size enterprise. A 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, which could dilute their ownership, control and independence. Moreover, their search for alternative finance may lead them into excessive borrowing, which can destabilise thier businesses and put themsevles and third parties 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 particluar ethos and standing. Meanwhile, even major public companies in need of risk capital tend to use their reserves and raise debt, rather than external equity, for fear of its impact on the share price and ultimately on their ownership and control.

Yet without risk capital, enterprises essential to the health of our society and economy may never get off the ground or grow. While serveral initiatives to address the equity gap over many years have brought some progress and success, the problem persists, exacertated by current financial and economic difficulties.

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 familiar practice of licensing. The way it works is that external investors would own assets used by the enterprise rather than a share of its equity. Businesses would pay to use these assets through a royalty on the sales revenues that they achieve. The system would reward investors through contracted royalties, while limiting their risk through the assets they own, whether tangible, like plant and machinery, or intangible, like intellectual property and brands.

Royalty based funding is also akin to the widely used instrument of leasing whereby assets are similarly owned by one party and used by another. While one kind of lease, the so-called finance lease, is closely related to borrowing, another kind, turnover lease, whereby a tenant uses premises in return for payments based on sales revenues achieved, is in essence a royalty fund.

Thus royalty funding would use proven mechanisms like licensing and leasing as building blocks, integrating these well known business models into a straightforward financing instrument based upon standard arrangements where the business, legal and taxation consequences should be well understood.

Royalty funding should be able to cover most of the core capital requirements of any reputable enterprise which is competently run on a business-like basis, and enable it to generate its own profits and reserves. It should be an entirely private arrangement between the investor and user, with proper incentives to encourage the latter 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. 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 risks.

Since royalty funding is risk capital for hire, rather than risk capital provided as ownership equity, investors would have no ownership or managment participation in the user enterprise. However, payments by the enterprise for the use of the risk capital are contractual obligations rather than discretionary distributions of profit through dividends. And in the event of failure, investor could re-take control of their property, rather than recover only what is left after prior claims have been settled in full.

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

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