In one episode of ABC's Shark Tank, the sharks were in a bidding war over the Rapid Ramen cooker. Two offers emerged that were deceptively similar: each with an entirely different impact on the entrepreneur and his company's future.

Which offer would you have taken?

Robert Herjavec, the older technology mogul, offered a $300,000 cash investment for 25% of the company. But his offer came with a "royalty" clause that would pay him back $0.75 for each item sold.

Mark Cuban countered with a $150,000 cash investment and $150,000 loan—for the same $300,000 total and the same share of the company—with no royalty.

"It's the same thing," said Herjavec, "Except that if you can't pay Mark back, he will end up owning your whole company."

"It's totally different," said Cuban. "If you grow as fast as you think, you'll end up paying Robert a lot more—and a lot faster too."

Who was right? Let's break it down:

Royalty

A royalty payment is generally defined as a percentage of sales, or a fixed dollar amount per unit sold. Either way, the royalty might have no defined end. Repayment is based on actual sales: sell more units faster, and the Shark gets their money back sooner; sell nothing and the Shark is left with no returns.

Loan

There's no question that a loan will have to be repaid, but that can be an advantage, too. Loans have a specific value, a known repayment schedule, and a finite life. Generally, a business loan will be repaid over 3 to 7 years. Of course, if you fall behind on repayments at any time, an investor is likely to "call" the loan or "convert" the loan to stock. In either case, the investor can take over ownership of the business and leave you with nothing.

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The good and the bad

Whether you take a loan or a royalty offer may depend on how certain you are about your own success. The two strategies differ when the business does very well and when it does very poorly.

If the business takes off quickly and does well over the short term, the royalty could cost a lot more than the loan. Additionally, since royalties are paid on every sale, the payments could rob the company of vital cash flow just when it needs it the most. (Growth can require much more cash than failure!) During that same period of rapid growth, a loan repayment schedule would remain unchanged, leaving more cash in the business to fuel growth.

On the other hand, imagine a business that starts slowly and never achieves much success. In this case, the royalty will cost very little. Low unit sales means low royalty payments. The loan, on the other hand, must still be repaid at the agreed-upon rate. In this case, paying the loan back could actually cost more—and require more cash—at exactly the time that the company can least afford it.

Decision time

There's no perfect answer. And on "Shark Tank" you can always see the angst on the face of the business owner as he or she struggles to decide between multiple offers. This time, Cuban prevailed. The business owner had sights set on rapid growth and believed that a loan from Cuban would leave more available in the short term.

Why Sharks ask for royalties

Perhaps even more interesting is how often, and why, Sharks ask for royalties. Why? Probably because as the show continues season after season, the Sharks are collecting quite a portfolio of small businesses. Eventually, even a wealthy Shark will run short of cash unless he or she can negotiate deals that return the cash as quickly as possible. Royalties—and, to an extent, loans—accomplish this.

In short, Shark Tank has forced these sharks to make a cash-flow business out of what should be long-term investing. I think they often care less about the company's future and much more about how fast they can get their money back—and how long they can continue to get paid royalties.

In my experience (in the real world—not on reality TV!), investors rarely worry about royalties. Perhaps that's the difference between a true "shark" and an "angel investor." Angels, with more reasonable terms, are more likely to deliver a simple cash equity investment, or at least a convertible loan on favorable terms. Frankly, it's a bit sad how bloodthirsty the Sharks on Shark Tank appear. Real-world angel investors are rarely so antagonistic, aggressive, or anxious to get their money back.

In any case, royalties and loans do have their place, but it's a good idea to calculate the impact that each would have on multiple future scenarios (success, failure, and in-between) before accepting any offer. Don't let your long-term business turn into a short-term cash machine for a disinterested Shark.

FAQs about royalty deals on Shark Tank

Below we have summarized the most important questions and answers on the subject.

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