The Reality of Royalties An expert explains why investors ask for them and what that means for you and your company.

Why would an investor want royalties? Doesn't he believe in my business?

The straight answer is no, he doesn't believe in your business. Investors are all about risk and return. The more risk they see in a situation, the more return they must have. By asking for royalties in lieu of equity, the investor is telling you that your company involves more risk than he's willing to take. Here are four reasons an investor may choose to suggest this route.

• The size of the investment is not in line with what the investor usually doles out. A royalty offer could be indicative of an outsize funding request (or the opposite).
• The stage of your startup doesn't sync with the investment strategy. The investor may concentrate on angel and seed rounds, whereas your business has moved beyond that stage to selling product.
• The investor loves the product but doesn't necessarily believe in the team behind it. Many investors will tell you they invest in people, not products or companies.
• The investor sees potential for a profitable business, but not the kind of explosive, hockey-stick growth needed to justify taking an equity stake in your company.

The good news is that royalty deals are fairly common, and you should be able to find general rules of thumb for many industries that will enable you to compare your offer to others.

Going into the negotiations, what matters most is the strength of your intellectual property. You want a patent (multiple patents are better), one with many years left on its protection—you won't get a good deal if your patent expires in a year. Other variables to consider: the extent of the royalty deal (units sold or time), exclusivity and uncertainty of the market. You can also negotiate a mix of upfront investment and royalties.

One tip is to suggest sliding royalty rates, with the rate shrinking year by year or after certain sales targets are met. This allows investors to limit risk at the start since they get their money back faster, while you share the upside of success down the road, with the ability to keep more of the future profits for yourself.

So don't be insulted by a royalty offer. It's an investment in your business. Keep a level head and negotiate hard. And remember that royalties will always be limited by how much profit can be made on the product. In some cases, paying royalties may be the best-case scenario for your company's future.