A Boston-based specialty finance firm is making inroads into Michigan with a little-known but ascendant type of financing.

 Arctaris Capital Partners launched its Arctaris Michigan Fund earlier this year in Detroit with the aim of building up a portfolio of Michigan companies looking to grow. Andrew Clapp, founder and managing partner of Arctaris, said more state-specific funds may be in the firm’s future.

Like a handful of other firms across the country, Arctaris relies principally on a security structure known as royalty-based financing, or revenue-based financing.

Royalties are not exactly a new concept, but this particular model is. In a nutshell, an investor will invest a certain amount of capital into a company, which then agrees to repay that loan as a fixed percentage of top-line gross revenue.

 The investor caps that return – say at five times the original investment – and gets a regular check until the investment is repaid. If the company has a bad month, the investor has a bad month. And because it’s booked as a debt, the investor is among the first in line to get paid.

If you want to know more about royalty-based financing, you have to go straight to the source. That would be Arthur Fox, the chairman of Royalty Capital Management in Lexington.

Fox originally began his career as a “serial high tech entrepreneur,” as he puts it. He founded three technology companies, two of which were financed with venture capital.

“We made money for the venture capitalists and some money for us as the founders,” he said. “But as anyone who’s done this will tell you, after you’ve gone through several rounds of venture capital … the dilution effect of equity financing becomes painfully obvious.”

In 1988, after selling and subsequently departing his third startup, Fox took his show on the road, mentoring, consulting and coaching other startups.

Equity compensation is common for mentors, he said, but “in most instances, that stock will never be worth anything. That’s the nature of startups.”

And because that stock wasn’t exactly “real money” at the time, those entrepreneurs were more inclined to call in Fox for any matter they could easily handle without him.

Fox wanted to nudge his clients to use his time more efficiently, so he came up with a proposal whereby he would accept stock for half his billing rate and invoice the company for the other half. The company would then keep those bills on their books until they started to sell its product or service, at which point the company would pay Fox a fixed percentage of their sales until it paid down his bill.

That compensation plan worked so well, Fox began to wonder if the same concept might work for a company looking to raise capital. And thus, the royalty-based financing model was born.  

“Its greatest advantage is that it’s non-dilutive. Every entrepreneur is trying to maximize the amount of capital they can raise and minimize the amount of dilution they experience,” said Scott Goodwin, a member of Wolf & Co. and head of the firm’s technology practice.

Indeed, that’s one of the chief benefits its proponents emphasize: cash infusion without dilution of the founders’ equity and no pressure to sell or force growth on a quick upswing.

“Ownership is near and dear to most founders and CEOs hearts, and they hate to give up equity,” Andrew Clapp, founder and managing partner of Arctaris, said.

While it’s in the investors’ best interest for the company to succeed and his firm will therefore provide any help the entrepreneur needs, BJ Lackland, CEO of Seattle-based Lighter Capital said, “We’re not sitting in the boardroom looking over their shoulders. We don’t do that kind of company building work.”

Investors like the model because it provides a steady cash flow, Fox said, though he concedes it’s not quite as “exciting” as the prospect of investing venture capital into the next Facebook or Apple.

But for every Apple, there are a hundred other smaller companies that may have mundane stories, but nonetheless can generate revenue for investors willing to give them a serious look. One reason Fox likes his model is because he says it redefines success to be something a little more feasible than making $100 million in sales in a year.

For instance, Lighter Capital, a Seattle firm that uses Fox’s model, finances smaller companies in the technology space, including an online education business and a company that offers online yoga classes, its CEO BJ Lackland said.

Royalty-based financing isn’t for everybody. It’s not ideal for seed-stage companies or capital-intensive businesses that require a big investment in infrastructure, like biotech or medical devices, Goodwin said.

The ideal candidate for royalty-based financing would be a company going through a growth period with a revenue stream in the foreseeable future.

“They don’t have to be making money, but hopefully they’re on a growth path where we can see them getting to profitability in three to four months,” Lackland said.

And for all its benefits, royalty-based financing is still something of a niche product.

“I don’t think it’s widely known amongst entrepreneurs,” Goodwin said. “They don’t view it as a common financing source until someone brings it to their attention.” 

Email: lalix@thewarrengroup.com