By Neil Johnson on 4th May 2018
Could royalty financing be the next big thing for investors in non-bank lending assets?
It is a sector worth more than $50 billion in North America, but royalty financing is a relative unknown form of raising capital in the UK and Europe, even among those well-versed in the intricacies of the alternative finance market. It could be an attractive option for small to medium size companies (“SMEs”) looking to raise money.
This is a significant evolution from royalty financing’s origins in the mining sector several decades ago. It works like this - a mining company receives capital to build a mine, in exchange for a small percentage of what the mine produces, for the entire life of the mine. The royalty company participates in revenue from the mine, and the mining company owners didn’t give up any control of their company. When mining begins, both parties share the results of future production, good or bad.
The model was so successful it has been adopted in most commodities, notably oil and gas, as well as pharmaceuticals, media, and franchises. The Canadians and Americans have lead the way in evolving the solution to fit almost any industry.
Most interestingly, however, is when the traditional royalty model became the basis of a new alternative financing solution for SMEs. With the lack of royalty finance awareness in mind, it is worth explaining where it fits into the alternative finance space and how companies – in any industry – can benefit from it.
To help you get your head around the model for SMEs, known as corporate royalty financing, it is best understood as a type of ‘corporate mortgage’. An established business exchanges a small percentage of its revenues over a long period of time in return for capital today. Like the mine owners, the company gives up a slice of future revenues with the benefit of no equity dilution.
Royalty payments, like a mortgage payment, include the principal as well as the interest, resulting in nothing more to pay at the end of the term. And the term spans 25 to 30 years, similar to your home mortgage or the life of a gold mine. Want to pay-out early? Royalty firms allow you to, just like banks.
The advantages are clear: unlike other options, royalty financing enables businesses to realise their long-term business goals without compromising owner control, diluting equity shares or adding debt to the business.
Since the royalty company is taking a slice of revenue from the business, it also means that the interest of the two partners are aligned – when a recession reduces revenues, the royalty reduces accordingly. One twist on the traditional royalty however, is that a corporate royalty will be subject to a collar - a maximum change up or down in any given year. Experience has shown that for a corporate royalty to succeed, the spoils of long term growth needs to stay primarily with who produced the spoils... the owners of the business.
Like any form of financing, it does not suit all situations. Where does it fit? It appeals to owner-managed, private businesses which have a long-standing profitable operation and want to keep control of their business. When a suitable business is eyeing an accretive acquisition, needing growth capital, mulling a minority shareholder buy-out, facing a debt refinancing, or planning ownership succession, royalty funding is a viable option.
Too often in the UK and Europe alternatives to traditional bank borrowing involve getting into bed with a Venture Capital or Private Equity Firm or even crowdfunding capital. For some companies, this is great and can help accelerate growth. However, it can come at a cost.
As well as being expensive, it also adds a significant pressure on the company to realise an exit which can often mean a sale to a foreign investor or another private equity house in the coming years. That decision is usually out of the hands of the original owners.
This is where royalty financing stands apart from other forms of alternative finance. It is already tried and tested in North America and its passive nature means the business stays in the hands of those who built it.
The peer-to-peer (P2P) business lending market has really taken off, with The University of Cambridge’s Centre for Alternative Finance (CCAF) estimating year-on-year growth of 99% between 2014 (£749m) and 2015 (£1.49bn) in the UK. In comparison to long-term-focused royalty finance partners, will these eager investors still be around in years to come when interest rates could have shot up?
Equity crowdfunding, whereby people can invest in an unlisted-company in return for partial ownership of the firm – typically start-ups and/or early-stage businesses – grew 295% between 2014 (£84m) and 2015 (£332m), according to the same University of Cambridge study. Most crowd funders are looking for a large return on their small investment, so for many stable old-economy businesses, they don’t attract the attention of the punters. Or if they do, like venture capitalists, the new ownership crowd will want to know how they exit. The original owners will face losing control, since crowd funders may only see their money again if the company IPOs or is sold-off to a larger competitor.
Royalty financing may be relatively unknown, but it has stood the test of time in financing many industries in America. The internet has made new forms of alternative finance sexy, but for established, well run companies seeking proper institutional capital, the ‘new’ solution of Royalty Financing and its track record of success has finally come to the UK and Europe.