For Start-ups, Another Source of Cash

Royalty-based financing gives start-up companies a nondilutive, albeit expensive, source of funds.

Last year Velico Medical Systems, an aging Beverly, Massachusetts-
based start-up with no products and no revenue, needed some money. The company had been “in perpetual funding mode,” CFO Tom Fitzgerald told a gathering on Tuesday hosted by The Capital Network, a Boston-area networking group. It had worked on products related to the handling and storage of human blood without any success. A new effort, which involved spray-drying human plasma, seemed promising, but prospects for a new source of equity capital were not as bright.

As it happens, Fitzgerald didn’t need the equity capital. Instead, he went back to a venture-capital firm that had previously turned down the small life-sciences company and emerged with a fresh infusion of cash through a nontraditional financing arrangement known as royalty-based financing.

In this arrangement, companies agree to pay a stream of income, or royalty, to the investor. The royalty can simply be a percentage of gross revenues or, as in Velico’s case, conventional royalty payments for intellectual property. Velico turned over the rights to royalties it received from a patent-licensing agreement it had with a large biosurgical-products company to the VC firm, OrbiMed Advisors. In exchange, Velico received a lump sum of money, free and clear of any future obligation. The deal closed last October, about eight months after the initial discussions about it.

Royalty-based financing is certainly not common, but it could be an increasingly available alternative for certain types of growing companies with steady cash flows, experts say. “I think we’re going to see more of [it],” says Dan Allred, senior relationship manager with Silicon Valley Bank. “There are a lot of companies out there that may not be high-growth enough to get the attention of traditional equity investors, but still have good cash flow and good margins,” both of which would make them more attractive for alternative structures.

LaunchCapital, a seed-stage venture firm based in Cambridge, Massachusetts, will make loans whose repayments are based on net sales, according to director of small business Heather Onstott, who also spoke at the Tuesday event. Other firms that are known for this type of lending are Arctaris Capital Partners, which recently raised $18 million for such purposes, and RevenueLoan.

The structure is no panacea, cautioned Fitzgerald, but it worked well in that it was nondilutive of the equity structure. Once a company pays off a royalty-based loan — and the term can stretch on for many years — it has no further obligation to the investor.

Cost is a major drawback of royalty financings, which typically carry an interest rate anywhere between 13% and 35%. In Velico’s case, complexity was another: creating a “true sale” of the royalties required setting up a special-purpose vehicle, which made for extra accounting work. (The structure of such arrangements can take several forms, noted Fitzgerald, including a true sale and a loan with royalty payments as collateral.)

“If we could have found a less-expensive source for the same money and the same terms, we would have, but that wasn’t going to happen for us,” said Fitzgerald. Given that, “this was a good alternative.”

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