Royalty-Based Venture Financing, Born in Boston, Could Shake Up VCs and Startups from New England to the Northwest

Every once in a while, an investment model comes along that turns the innovation community on its head. The venture capital industry, still less than 50 years old, is one example. Now an emerging paradigm called royalty-based financing, applied to early-stage startups, may be another. The approach has its roots in the Boston area, and is starting to generate some serious buzz in the Northwest. If you’re a VC, angel investor, or entrepreneur, it definitely needs to be on your radar.

The concept of royalty-based financing is simple. Instead of buying equity in a young company, an investor agrees to receive a percentage of the company’s monthly revenues—up to a limit of, say, three to five times his or her investment. Instead of waiting five or 10 years for a startup to go public or get acquired, an investor can start seeing returns almost immediately. This approach means investors should be able to fund a much wider range of startups than just those that typically receive venture backing—the ones that have potential to grow huge, fast. The downside is that your returns are capped, so if you do end up backing the next Google or Amazon, you still only get five times your investment back. Meanwhile, for entrepreneurs, it provides startup money without having to give up an ownership stake in the company.

Royalty-based financing is not new, but it’s only been in the past few months that investors around Seattle, including the seed-stage fund Founder’s Co-op, have been openly exploring the model. In New England, a few investment firms are actively using it, led by Lexington, MA-based Royalty Capital Management, Wakefield, MA-based BDC Capital, and Portland, ME-based Rockwater Capital. Harvard Business School professor Clay Christensen (of The Innovator’s Dilemma fame) is a supporter of the model, and views it as disruptive to the venture capital industry.

The idea actually dates back to mining companies getting financed to dig for oil, natural gas, and minerals, and government-funded economic development programs. But it is getting renewed interest from VCs and angel investors who increasingly need returns fast, in a tough climate for exits. Indeed, royalty-based venture financing “has the real potential of becoming a major new sector in the private capital market,” says Arthur Fox, the founder of Royalty Capital Management, who first used the approach with startups in the early 1990s.

Back then, Fox was an advisor to several startups; he’s an MIT alum and was previously an engineer with HP and Westinghouse before co-founding three tech companies of his own. He first tried out the royalty-based idea as a way to get compensated by the companies he was mentoring, instead of taking some stock. He found that this made them more efficient with his time, plus he would get paid every month. So he decided to try out the strategy as an investor. “It changed everything, because the normal criteria in selecting companies as a venture capitalist is a high-growth one,” Fox says. “When you invest in a company, buying stock and equity, you have no way of getting out unless they become significantly large enough to have a liquidity event.” With the new approach, he says, “every month you get a check, and it doesn’t matter if they ever have an IPO, or get bought out.”

Fox’s two previous funds have returned good profits. His biggest win was Andover Advanced Technologies, a multimedia software startup that had no revenues when he originally invested $100,000 in 1993. After two years, Fox had gotten back $125,000 in his cut of the revenues, and he invested in a second round with an angel investor, in which he took some equity. The company (renamed went on to ride the dot-com wave with a successful IPO in 1999, and was acquired for $1 billion by VA Linux Systems in 2000. Fox’s stock ended up being worth $15 million. It’s an example, he says, of how “royalty investment lets you get your foot in the door, evaluate how the company is really doing, how management is doing, and you may have the opportunity to participate in a follow-up round with much more knowledge.”

Of course, it also points out that if you want a home run, you need a conventional equity-based deal. And that’s the main objection most venture capitalists have with the royalty-based approach. While it may broaden their options of who to invest in, it goes against the high-risk, high-reward approach they’re used to. They also wonder why more investors aren’t trying the approach, if it’s so successful.

But this ignores the dire reality of today’s financial markets, says Thomas Thurston, the founder of Portland, OR-based Growth Science International, a research and consulting firm focused on predicting whether businesses (everything from startups to public companies) will survive or fail. “Venture capitalists say, ‘I don’t know if I’m comfortable capping [returns] at 5x,'” Thurston says. “But on the other hand, you’re probably not getting 5x right now, so you’d be perfectly happy.”

Thurston has recently helped bring the ideas of royalty-based financing to the Northwest. Originally trained in law and business, Thurston was with Intel Capital when he was invited to do a year-long research fellowship at Harvard Business School with Clay Christensen in 2007, focusing on rigorous tests of Christensen’s disruption theory (that’s worth a separate story). One of the many ideas the two came across was royalty-based financing, through meeting with Fox back East. Thurston has since been working with Christensen on a study of royalty-based financing. He concludes that “there are enough circumstances where it really is a good tool,” given the traditional limitations VCs face.

“So for that reason, I think it’s very fun,” Thurston says. “No longer is funding gated by the likelihood of an exit. That’s very significant.”

Perhaps what’s most interesting about the approach is that it could enable many more kinds of startups to get off the ground, and more young companies with revenues to grow. That’s compared with the 2 percent or so of all businesses that would be attractive to a VC. Given the difficulty entrepreneurs are facing these days to get seed- and early-stage funding, it could be a perfect match. “The alternative for a lot of businesses is nothing. It’s awesome for the entrepreneur,” Thurston says. “It gives you less pressure to grow and sell.”

Looking to the future, Thurston thinks that while some intrepid VCs will try out the royalty-based approach, angel investors “will be the ones who do the earliest experimentation and start to prove it out.” That’s in part because they don’t usually have limited partners to confirm it with. “I think it’ll feel less sexy to a VC,” he says. “But to VCs who are innovative, they’ll say, ‘Sexy or not, I like getting good returns.’ Imagine being a VC, you make an investment in September, and by October you’re getting revenues.”

Fox, for his part, says his next step is to raise a larger fund in the Boston area, probably on the scale of $25-50 million, and then start pools in other geographical areas. The idea would be to invest $1-3 million in emerging companies that are doing a few million dollars of revenue a year (“there are a lot of them,” he says). Fox says he’s still looking for the right partners.

So is royalty-based venture financing poised to take off in the Northwest, and beyond? “I would love it, but I’m heavily biased,” Thurston says from Portland. “I’ve been focused on predictions. There is momentum happening in my small world, and people are wanting to hear about this.”

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41 responses to “Royalty-Based Venture Financing, Born in Boston, Could Shake Up VCs and Startups from New England to the Northwest”

  1. David says:

    This is the first I’ve heard of this model, but nevertheless it seems to me that it would not seriously compete with traditional VC investment dollars because the type of company seeking this sort of funding would look very different from a traditional VC portfolio company. The royalty model, at least cursorily, has many of the mechanics of a loan, right? As in, a chunk of operating cash flow is diverted away from growth to pay back investors. Am I missing something?

  2. David, you bring up a great point. The deal structure is actually pretty similar to a loan. As I see it, part of what makes the model “disruptive” is that it doesn’t look like it would compete seriously with VC. But it’s a way to get your foot in the door with promising startups who wouldn’t normally get funded. Meanwhile, VCs need some returns.

  3. David says:

    Gregory, thanks for the response. What kind of “seniority” (for lack of a better term) are you seeing for these deals?

  4. I’m not sure I see how this presents a greater opportunity for young companies to be funded. The companies that would presumably be chosen for this kind of model are companies that already have significant revenues. Those companies are also in prime position for equity-based funding. Companies without revenue are still going to be subject to the same dog and pony show that accompanies equity-based fundraising.

    I do see the appeal of this method for entrepreneurs who don’t want to give up equity.

  5. Jeff Schrock says:

    Greg –

    Great Article. This model is reborn and ascendant (we just got a proposal for this type of financing in one of my portfolio companies)

    Like others, I’m not sure it’s a threat to (or alternative instrument for) VC’s as they (we) typically what all cash flow going towards growth and are looking for big market opportunities.

    I have seen lots of great business plans, however, for companies who have a realistic shot at doing $10 – $20M per year in rev’s with unusually high net margins. This type of company would be a good candidate for royalty based financing.

    One of the things I’m curious about, however, is the potential for fraud. Do entrepeneurs bind all their future products to this royalty scheme? Do the investors also take board seats and have protective provisions? Does the financing manifest itself as a loan (secured?) or is it merely a business agreement? It seems to me like the “switching costs” of mining projects are considerably higher than those of a website but this financing vehicle could be very viable.

  6. Gregory T. HuangGregory T. Huang says:

    David, I’m seeing a high level of seniority in these deals. On the other hand, the analysts you hire need not be Harvard MBAs — they can be bankers or CPAs, from what I hear.

    Bill, very interesting point — I’d like to hear from more entrepreneurs on this.

    Jeff, as I understand it, the investors don’t usually take board seats. I’m not sure how the contracts work with regards to future products — probably needs to be negotiated. But I hear the terms can be less risky for investors, as this only involves contract law.

  7. Phil Colburn says:

    Great article. I would have loved to have seen some specifics. I know each deal is different, but what would the range of royalties on revenues run???

  8. Note that at the end of the article it says “The idea would be to invest $1-3 million in emerging companies that are doing a few million dollars of revenue a year.” Exactly. That’s what royalty capital is good for. Startups? Pre-revenue? STEM businesses that are going to need a lot of tech development? I don’t think so. Royalty will grow to serve the niche that needs it–which I believe is in fact quite large. But I can’t imagine it as a replacement for existing VC terms in the majority of cases…though who am I to say? I’m not Professor Clay “Disruption” Christensen!

  9. See this article: for discussion of the sort of deal FoundersCoop is likely doing. The Xconomy article doesn’t make a clear enough distinction between “R Class” type deals, where there is royalty/equity hybrid and pure “Arthur Fox” type royalty deals where equity isn’t included because the entrepreneurs have no interest in an exit through acquisition (typical family-business-with-growth-potential situation, which has been the bread and butter of royalty capital).

  10. Greg,

    Enjoyed reading this article. Couple of things for you, David and Jeff on what we’re seeing:

    (1) Most of these deals that have been proposed include some type of equity component – usually a warrant. Hard for anyone to step away from that equity upside – especially with startups.

    (2) Great clarification that these are a lot like bank loans. Usually subordinate to senior debt, but many of the reps/warranties/covenants of bank loans.

    (3) Also like bank loans, if you default you risk owing the entire unpaid 3-5x return. Same for a change of control – they want their unpaid return off the top.

    (4) Some have board seats, and some don’t. Really seems more driven by the companies. Because of the nature of the investment, board presence is less critical for the investors – more likely to want information rights.

    (5) If you do need to grow quickly/need VC capital down the road based on a change of strategy by a competitor or whatever, the typical RBF investor may not have substantial follow-on funds readily available. And then you’re going out to VCs with this RBF arrangement in place which will go to valuation.

    (6) Definitely not disruptive to the VC model, which isn’t broken – it’s just on pause (generally speaking). Smart early stage investors are still cutting very solid traditional vetnure capital Series A deals, and two years from now will look brilliant for their boldness over the past 9 months.

    (7) RBF model seems appropriate for the rare high revenue company that doesn’t need much capital but is willing to put the company assets at risk of default and give up 3-5x for it.

    • We received a round of RBF 7 months ago and we are getting ready next week to pay it off. Borrowed 1 mill. Paying back 1.5 mill minus payments. Nit a bad return for our lenders bUT we only had to give up 1.5%. So, though I hate to pay a50% return on a 7 month loan, I believe that it saved me a larger amount as equity investors wanted much more than I wanted to give up. It’s a give and take but it worked for us.

  11. Ron Kysiak says:

    I ran into this model when I worked in New Haven in the early 1980’s. At that time the Connecticut Product Development Corporation a State funded entity – used the royalty based model exclusively to invest in new companies. It got rid of a lot angst re valuations and ownership, with the State being a silent partner, but a partner nontheless.

    Of course if a company is, say, a consulting company rather than the producer of hard products, the royalty model gets rather complicated but I am sure the deal can be structured to allow for such investments.

    I do not know if venture capitalists would be happy with the royalty requirment on the books when they look to invest later, but at least it has a finite end and therefore can be planned for much like the debt models mentioned earlier.

  12. Doug Elliott says:


    Excellent article with much food for thought. Royalty based investment is an excellent way to capitalize the intangible property value of new businesses with the intangible properties themselves. We are doing this with patents and other intellectual properties using a ‘sale and license-back process’.

    Basically investors purchase some or all of the intellectual property and license it back exclusively to the entrepreneur for a term of years in exchange for defined and periodic royalty payments. The sum and timing of the royalties can be capped or include a variable rate.

    The intellectual property acts as the investor’s security interest during the term of the transaction while the license-back gives the entrepreneur all the ‘freedom to operate’ he/she needs to be successful. Because this is an asset based transaction, the entrepreneur keeps his/her stock equity for a later use.

    One option allows entrepreneurs to re-purchase the intellectual property assets at a marked-up basis as part of the deal. Our sale and license-back process is itself patented which lends additional proprietary value and protections to the intangibles that are so acquired and back-licensed.

    Royalty based financing can do for the Knowledge Economy what the sale and leaseback of factories and equipment did for the Industrial Economy. Thank you for illuminating the benefits of this new financing concept for the investors and entrepreneurs alike.

  13. It is great to be raising people’s awareness re: royalty given today’s market. Vested For Growth (VFG) has been investing in existing NH based companies using royalty financing for the past 8 years and have found it both useful and profitable.

    The real power of royalty is that it provides a way to invest in more deals. Instead of chasing the same few “gazelles” – (less than 5% of companies are appropriate for equity), royalty allows VFG to bring growth financing to a much larger segment of business in our economy – existing businesses with owners who otherwise would balk at giving up ownership/control. And royalty still offers the investor a “high touch” investment — though the nature of the partnering is based on win/win persuasion and not decision making due to lender liability issues. It also can provide the investor solid rewards, largely due to having payments start the first month (perhaps this is a good way to round out an equity portfolio with more income oriented returns). Also if you use royalty with established companies, and not start ups, there are fewer homeruns and strike outs but many more singles/doubles.

    I would also point out that investors do not need to stop offering equity, but simply add royalty to the array of deal structures that you offer entrepreneurs. The result will be better for both parties, whether its royalty or equity. I don’t see royalty as disruptive – good equity deals will still get done. However when established businesses get turned down by banks and they feel like their only other choice is equity, they may feel forced into doing equity – this is a recipe for a “capital mismatch” which is bad for the entrepreneur and bad for the investor and hopefully market awareness of royalty will serve to limit that.

  14. Phil Colburn says:

    As has been pointed out, these structures are basically loans (as opposied to equity). Even the sale and leaseback of IT. Can anyone comment on whether these deals avoid the usury laws in those states that have them (i.e. Calif,)???

  15. David Lukas says:

    Again, I have basically no exposure to this kind of financing… but it seems to me, based on the comments, that a company facing a choice between equity and royalty financing is not a realistic scenario. It seems it would really be a choice between debt and royalty financing.

  16. Jeff Schrock says:

    @Phil – regarding usury laws, perhaps the lawyers here (Gordon??) can answer better but I can’t see how that would apply. Usury applies to interest rates and doesnt’ even capture many fee provision (payday loans). quick glance at wikipedia (FWIW) seems to confirm…as royalty based returns are inherently unknown at the time of making the deal.

    @ Lukas – agree that many companies could face debt vs. RBF choices but high margin, high growth (but still not cfbe or debt eligible) companies could also use RBF. Equity is nearly 100% dependant upon exits, so if an equity investor doesn’t see an exit (which are increasingly rare) they don’t get in.

  17. Jeff – they can definitely be structured to avoid usury issues. Varies state to state, but I agree with you. And if Wikipedia says it’s true, then it’s true. :)

  18. Jeff Schrock says:

    @ Gordon – thanks! And don’t worry too much about Wikipedia. We still need attorneys :)

  19. Bad idea: If revenues include R&D funding, this taps into capital that should be used for value creation. If revenues are from product sales, investors will have to wait 12 to 15 years (or more!) to get any return from early stage companies. Equity aligns investors and management much better.

  20. Doug Elliott says:

    Some comments on the comments.

    Re: John Hamilton’s comments- you are dead on in recognizing that royalty financing transactions significantly broaden the scope of deals that early stage capital can invest in. Because the exit strategy is hard wired into a royalty based transaction, if offers competitive returns without speculating on the future vagaries of the public markets. Plus there are no extra exit costs compared to IPO’s. And it takes nothing away from the equity option. However as Gordon Empey previously noted, financing the intangible assets of a business first will provide significant equity valuation information which can make future equity negotiations more transparent to entrepreneur and VC alike. Whether VC’s will become averse to follow-on equity financing in existing RBF’s because of this new transparency remains to be seen.

    Re: Phil Coburn’s comment- to characterize RBF’s as disguised loans misses the point that a royalty is a form of rent of specific kinds of property. In the case of most new companies this means the intangible property assets and more specifically intellectual property assets. The better analogy is capital asset leasing- like rail cars, trucking fleets and the like.

    In a bona fide sale and lease back the seller-entrepreneur gets the benefit of cash on the books and a 100% write off of the lease expense as incurred. The investor gets a depreciating asset so its taxable income is offset by the periodic depreciation of the purchase price. In the RBF model,the lease becomes a license and the depreciation becomes amortization. Comparing to traditional lending, there can be over 40% in future tax savings to the entrepreneur and 40% more income to investors when measured against the initial RBF investment.

    But it is also true that, depending on the investor’s use of debt, a sale leaseback of real property can be treated as a loan for accounting and tax purposes. The same is generally true for the sale and license-back of intangible assets. So, as to usury laws, it will depend on the debt and equity structure of the RBF to determine whether the transaction is a ‘true sale’ or a loan.

    Finally, one comment/question for the author and commentators- It seems to me that RBF investments in selected business or technology sectors could create pools of related intellectual property rights that would be strategic to the investors and possibly to entrepreneurs. This would be in addition to the economic returns of the royalty streams of each RBF. Is the VC/ early stage investor community ready for the addition of such a paradigm?

  21. Doug Elliott says:

    Re: Rastetter comment:

    William- disagree with your blanket statement on R&D funding. What do R&D monies fund in the first place? Rented office/lab space, leased lab equipment, leased software- so why are you against having some R&D money fund royalties on earlier and now re-capitalized R&D? Especially if current R&D is building on a previous R&D platform.

    Whole Foods doesn’t tie its money up in owning a truck fleet- it leases them so it can put the cash it saves in the groceries they transport.

    Same with intellectual property, the kind of asset that R&D builds. Who wants to tie up a couple of million $ in R&D sunk costs for patents or trade secrets and then wait 12-15 years for a pay off? Sell it off now, license it back for a fair royalty and use the surplus cash to fund commercialization.

    This is what savvy investors look for in successful companies. Good focus and good cash flow management. This is what RBF’s bring to the table.

  22. The problem with this type of financing, at least for bio-pharmaceuticals, is that the risk/reward is not there.

    Usually you want to at least to dream about a 10X return, even though that rarely if ever happens. It will be interesting to see if anyone tries this with Biopharma…

  23. Doug Elliott says:

    To Drew’s comment:

    The 3x-5x-10x returns mantra of Venture capital investment theory is simply naive in the current economy. The real objective, as in all investing, is the sustainable total return on capital under management. Based on VC current activity in Bio/Pharma it appears that less than 10% of deals are hitting the 10x mantra point. Investors could do just as well betting four random numbers on a roulette wheel and without management fees.

    Total capital returns for the bio/pharma industry (includes un-amortized R&D investment as capital) is just under 20%/yr and falling. The foods industry is slightly higher. These are similar to the returns on capital in the leasing industry which is also similar to the expected rates of return on equity capital for RBF.

    The VC industry has relied far too long on a few celebrated outlier returns realized by an even fewer number of VC celebrity investors. Using RBF to focus on capitalizing assets- which should now include intellectual property- is a far more reliable, if less glamorous way, to really serve the capital provider in new technologies.

  24. The non-dilutive feature of a royalty makes it very attractive to companies that don’t like what an equity round does to their ownership. But as some point out, this isn’t really well suited for early stage financing.

    Royalty financing works better with later stage companies, and it is more akin to sub-debt. In fact, at Arctaris we’re using a royalty in place of stock warrants, so there is no dilution of ownership. But when all is said and done, its use might be better suited for the company needing debt to replace the bank line it may have lost or had reduced during the recession.

    It’s also a highly transparent financing structure that eliminates the black box valuation on equity that is so offensive.

  25. Chris Farm says:

    I think that this model is an interesting idea and certainly has it’s place in creating financing for startups. However, the biggest downside to this financing model is ironically one of the biggest upsides. The fact that the investor doesn’t own any shares in the company essentially nullifies any influential business decisions that the investor could make in the future. For example, if the investor wanted to replace the current CEO, the investor would have no say in making that decision unless he’s on the Board.

  26. Ken Smith says:

    Royalty-based Venture Financing is a very compelling model, but it still leaves a void for start-ups that are just $100K – $500K away from launching into the market. Traditional VC is not investing at this level, and angels and groups have moved more towards sharing deals with VCs. There needs to be a new VC model for pre-revenue investing that rewards entrepreneurs, investment professionals, and thier investors.

  27. Suzie wu says:

    This article was just brought to my attention. I have been using this practice quite a number of years in China without even knowing that such a model exists! One example was an early stage deal. It needed working capital to generate revenue. So we structured a debt/equity structure with monthly payback via revenue. To ensure fund safety, we put the major shareholder’s house as part of collaterals. We held certain administrative rights and a board seat. Eventually, the company’s revenue grew to a level that a traditional vc invested in the company. We got our money back, with 35% irr realized and warrant to be exercised. We are doing another one now with the company received two term sheets from very reputable vcs already. Based on our experience. there are certain characteristics for this type of companies. It also requires a broader knowledge from investors.

  28. Suzie- Sounds like China is on a leading edge of the global economy (again). We have lots of RBF deals state side waiting for savvy investors like you. Might very well be a great place to park part of the Chinese trade surplus. Certainly better returns than T-bills. If you use a sale/license-back model there are great tax benefits for US start-ups with tax loss carry forwards. It also improves investor returns with amortization tax benefits. Check it out on the CICM website.

  29. VanessaElizebeth says:

    That’s a great piece of article.Thanks for writing it up.

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