“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.”
