From SCORE Richmond by Doug Carleton:
How does a company raise capital to grow or even to start a new business? Raising investment capital is generally one of the most difficult and painful things an entrepreneur has to do. Generally, the default method is selling a percentage ownership in the company in return for investment. One of the risks that come with this strategy is dilution of your ownership. You no longer own 100% of your company, so if you are successful you get less of the rewards. Still, selling equity is by far the most common way of raising investment. But another risk might be that you are not as successful as you projected you would be and what sold the investor on making the investment in the first place.
Since the investor has only a minority interest in your company, and since there is no market for the stock assuming that it has not gone public, the investor is stuck if you cannot or will not buy back the stock or if he/she can’t find another buyer. This could potentially cause a problem if the investor is unhappy enough. The investor might file a lawsuit for misrepresentation for example. This is probably highly unlikely because it would be extreme and costly for both sides, but an unhappy investor is not something you want to deal with because it could take you away from concentrating on your most important job, which is running the company.
Another way to raise capital that you could consider might be some sort of revenue-sharing arrangement – royalties. Royalties have been used in industries such as oil and gas, coal etc. for decades. Say an owner owns a piece of land under which there might be oil or coal. A mining company comes along, wants to drill, and offers a royalty on each gallon of oil or ton of coal extracted. The land owner still owns the land. So coming back around to a startup or early-stage company, a royalty on revenues might be worth looking at. There are no rules or guidelines on how to structure such investments. Every deal is a snowflake. One example might be a royalty of X percent until the investor receives some percentage above the original investment. Another might be a note with a royalty attached. Such a structure would give the investor a definite exit point which is something that is almost always required in the venture capital industry.
With revenue-sharing the most critical factor of all is that you keep 100% ownership in your company. This could be particularly important at some point in the future if you become a serious candidate for a larger venture capital investment. You will still own all of your stock enabling you not to have to be as concerned about additional dilution, and it also means a cleaner deal for potential venture capital investors because there is only one class of stock – yours.