Understanding Royalty in Startups: A Guide for Entrepreneur

Introduction

A great idea needs funding to become a practical application. The most crucial decision a startup or entrepreneur needs to make is how much of the revenue to share in exchange for funding for growth. There are many options for generating finances for ventures such as bootstrapping, angel investing, venture capital, crowdfunding, debt funding, etc., and each comes with its own disadvantages and advantages. One such quite underrated but potentially beneficial option is a Royalty in Startups agreement.

The concept has been used by musicians, actors, authors, painters, etc,. for generations, wherein they are paid a small fee every time their creation is viewed, used, or sold. If you research the personal net worth of some of the famous musicians and their earnings in royalties, you will understand the value of royalties. For entrepreneurs, royalty financing, or revenue-based financing, or convertible royalties have several benefits that make them a lucrative option to consider.

In the paragraphs below, we will discuss about how royalties in startups work, their types, pros, and cons, and how to get a royalty funding as an entrepreneur.

What is Royalty for Startups?

A royalty is a payment made to an individual, group, or entity in exchange for use of their asset. Royalty financing is a type of financing in which the investor injects upfront capital into the startup and receives a percentage of the startup’s future revenues. In this type of innovative financing strategy, royalty can be in the form of capital, intellectual property, rights, and others.

The advantage of royalty funding over traditional loans and equity funding is that it can have a flexible and scalable repayment structure which is tied to revenue generation. For example, a startup who is looking to developing a fuel cleansing device will need other auto parts for manufacturing. They might offer royalty payment to the makers to be paid as the product starts to make profit. Once the pre-decided royalty cap or a specific return amount is reached the royalty agreement terminates.

Startups use royalties in the following different ways:

Royalty-Based Finances: Investors lend funds to the entrepreneurs in exchange of a part of future revenue that they might generate.

IP (Intellectual Properties) Rights: Startups agree to pay an amount in exchange for the use of patent products, trademarks, or copyrights for their product or service.

Franchise Royalties: This is the amount the business pays for operating under a brand name.

How is the Royalty in Startups Calculated?

The calculation varies typically with the amount needed, the industry, the stage at which the startup needs funding, and the negotiation between the investor and entrepreneur. Royalty fees can be paid on the monthly or quarterly basis until the investors get an ‘x’ times amount back. Unlike other funding types, royalties do not involve an interest payment or gain an ownership or control over the startup.

Types of Royalties in the Startup

Some common types of royalties in a startup that an entrepreneur can seek:

(1). Revenue Based Royalties

This is a system wherein the investors provide a one-time capital influx and are paid back in the form of a percentage of revenue until they earn a multiple of their investment. This reduces the pressure of repayment during slow business periods.

(2). IP Royalties

This is commonly earned by creators or artists and is often sought by pharma companies and creative industries in exchange of patents, copyrights, or trademarks.

(3). Franchise Royalties

This is in the form of a franchise fee that the entrepreneur pays an established brand.

(4). Licensing Royalties

Media, software, and entertainment industries use this format in exchange for the use of licensed software, music, or other content.

Based on the way Royalty Fees are Paid, Royalties can be:

Fixed fees that remain constant regardless of the revenue earned. They are easy to calculate but does not encourage marketing or innovation investment.

Variable royalty fees are the amount that varies with the sales volume, profit, or performance. This is a more flexible option and can earn higher margins.

Minimum royalty fees are preset minimum amounts or rates that are to be paid to the investors by the startup regardless of the profit made through sales. It is generally stated as ‘amount’ or ‘revenue percentage’ whichever is higher. This type of royalty fee reduces the risk for the investor and the startup but can be a burden to the startup during low sale periods.

Maximum royalty fees are the amount that is capped at a maximum amount regardless of the sales. This type encourages the startup to be more competitive but limits the investors earnings.

How is the Royalty Amount Calculated?

When an entrepreneur gets into negotiation for royalty funding for his startup, the aim is to be able to scalp up without feeling the financial burden.

The Royalty Rate varies greatly with many factors such as:

Exclusive or Nonexclusive royalty

The amount of the upfront sum that is being paid

Industry Standard Royalty Rates

Market Potential

Intellectual Property Stage

Related Intellectual Property need

The Amount of Investment Required

Pros of using Royalty Financing for Startups

No Equity Dilution: The entrepreneur or founders retain full control of their startup without an equity dilution or ownership sharing.

Flexible Payments: Unlike loans or debt financing, there is no need to pay at a fixed schedule. The terms can be flexible and tailored to the investor’s and entrepreneur’s preferences. This means that the startup can adjust the cashflow as per its own goals and profitability margins.

Attractive to Investors: They get a share in the company’s growth as per revenue sharing model.

Quick and Easy Funding Access: Cash strapped startups benefit from royalty financing because it is more cash friendly and they only need to repay when they start making revenue. The investor also feels comfortable to invest without much hassle of profit sharing and asset and liability calculations.

Aligns with the Interest: Since both parties benefit from the growth in revenue and value of the startup, there are fewer chances of early exits. The investor is motivated to support the company’s growth and success.

Access to Proven Technology or Brands: The entrepreneur gets access to top brands and the latest tried and test technology which gives the startup an edge over other competition. Using an established brand name with proper permissions increases customer’s trust.

Lower Upfront Costs: Gaining a royalty funding reduces the initial funding that the startup might require to grow and expand. Since the entrepreneur does not have to pay for the full rights and the return starts when profits start to come in, they have the window to develop, market, and sell the product without hassles.

Cons of using Royalty Funding for Startups

Ongoing Financial Commitment to Loyalty Payments reduces the cash flow and profitability of the startup. Reduced profits mean less money for growth and innovation.

Limits the Growth Potential: With a royalty sharing model, the startup does not have the option to give equity to employees or customers, which can reduce the retention rates. Also, the entrepreneur does not get an exit option in royalty funding.

Higher Total Cost: Sometimes the startup might end up paying more than a traditional loan amount because of the percentage-based royalty payments.

Might feel Restricted because of Lack of Autonomy: If the entrepreneur wants to change the product according to customer’s needs or preferences, they might not be able to do so because of the limitations of rights.

Final Thoughts

Royalty in startups is a unique funding alternative for an entrepreneur to grow their business without having to sell his share in the business. Royalty offers flexibility and scalability potential and is a perfect option for startups who already have a steady revenue stream and are looking to scale or for entrepreneurs who want to retain equity and control in their business.

Amit Bhateja