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Risk Capital for Hire: a guide to royalty funding

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Ian Whalley, the author of Creating Risk Capital, describes a fresh approach to the financing of small and medium-size enterprises.

The provision of risk capital to small and medium-size enterprises (SMEs) presents a major challenge for the financial services industry. In fact, the provision of any kind of capital to SMEs has long been difficult, evidenced by a raft of initiatives, both public and private, to address the problem. These have ranged from the establishment of a specialist institution, ICFC (now 3i), private investor networks, venture capital and private equity firms, new share markets, loan guarantees, tax incentives and direct public finance or subsidy. But despite much progress and success, the problem persists, exacerbated by the current severe financial and economic difficulties.

Much SME financing has traditionally been provided by way of bank overdrafts and loans. However, these may be unsuitable where the real need is for risk capital, because they must be repaid in full with interest, on demand or on schedule, regardless of how successful the enterprise is. Such borrowing may also involve charging assets as security, personal guarantees from owner-managers, restrictive covenants and hefty restructuring costs in the event of re-scheduling.

Yet risk capital brings its own problems, especially if it comes in its classic form of equity, because equity capital is also ownership capital. Most owner-managers value their independence and do not wish to share the ownership and control of their business. Moreover, most financial institutions are not interested in providing equity capital in relatively small and uneconomic amounts. 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 all who deal with them at serious risk.

The aim of this article is to describe a fresh approach to 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.

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 enterprise rather than equity in the enterprise. Enterprises 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 could be both tangible, like plant & machinery, and intangible, like intellectual property and brands.

Another well-known asset finance instrument, where the property of one party is used by another, is leasing, which has grown into a major financial services industry. One kind of lease, known as a finance or capital lease, is very similar to borrowing. However another kind, the so-called turnover lease, whereby a tenant uses premises in return for a payment based on sales revenues achieved, is essentially a royalty fund covering one particular property.

Royalty funding uses such 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.

For royalty funding to work, investor interests must be properly protected with full asset-backing, and 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 royalty fund 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 formal ownership or management responsibilities in respect of user enterprises.

Royalty funding would benefit both owner-managers, who gain access to risk capital while retaining ownership and control, and investors, who receive a contractually committed and risk-related return alongside the security of asset ownership. This provides an opportunity to set up specialist royalty funders, supported by financial institutions, which could build up portfolios of royalty fund investments in SMEs.

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; moreover, in the event of failure, investors can re-take control of their assets, rather than, as in the case of equity investments, recover 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 risk capital for SMEs; 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.

Creating Risk Capital: A Royalty Fund Solution to the Ownership and Financing of Enterprise was published in June 2011 by Harriman House

Ian Whalley qualified as a chartered accountant, working in the UK, Africa and Europe. He went on to specialise in project finance, firstly at a merchant bank based in London and New York, then at a research development and licensing organisation, and lastly in the financing of public service projects. He has written Creating Risk Capital to describe some of the problems he encountered, and propose solutions.

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