It may be the simplicity and directness of the relationship which is difficult for some to understand. The thought of “How can anything this simple be so good for both parties?” and “there must be a catch”.
Revenue royalties (royalties) are simply a contract between an investor and a company, obliging the company to pay the investor a percentage of its future defined revenues for an agreed period, in exchange for the investor paying the company an agreed amount for the obligation.
The revenues can be tied to the company’s overall sales, the company’s sales in specific geographic areas, or specific product sales or revenue levels in excess of agreed amounts over agreed periods.
The royalty can be simple or complex depending on the needs of the parties and the terms of the contract. The percentage of sales paid to the investor is called a royalty rate.
Especially in startups or early stage companies, there will be investor protections to which the company will agree, in order to persuade the investor to buy the royalty for a lower royalty rate. It is broadly accepted that the lower the risk in the risk/reward calculation the lower will be the cost of funding for the company and also the return for the investor.
The structuring of a royalty which offers the investor capital loss protections is the way we recommend reducing the financing costs of money for the company.
The company will need to project the annual revenues expected, assuming the sale of a royalty on known terms, which will generate royalty payments for the investor. Minimum royalty payments can be assured and can be capped. The less risk the lower will be the investor return.
Therefore, it makes sense for the company to assure the investor of what it believes to be easily generated revenues, and negotiate a benefit for the company if the minimum levels of revenues are exceeded.
Early stage companies will typically project significantly increasing annual revenues in early years, more than a 20% Compound Annual Growth Rate (CAGR), while established companies will generally project a lower CAGR.
Of course, there is a greater risk of early stage royalty issuing companies being unable to attain the projected level of revenues compared to established companies, therefore the expected returns for investors will have to be higher for these investments with greater risk.
The royalty payment periods we recommend are between 10 to 20 years, depending on the needs of the company and appetite of the investor. However, and most importantly, we believe the royalty issuing companies should have a right of redemption, permitting them, on agreed terms, to terminate outstanding royalties. The terms of redemption will be such that investors will benefit from issuers exercising their possible right of redemption. It is the issuer’s ability to terminate the royalty which will encourage managers of fast-growing companies to use royalties, which lacking this redemption right might block: additional financings, the issuer going public or selling the company.
The most important reason for business owners to choose to finance using royalties instead of selling stock in their companies is that royalty investors do not own any of the company, only the agreed percentage of its revenues. Therefore, royalty investors, unlike equity investors, are not concerned with the reporting of ever-increasing quarterly earnings per share and do not pressure management to go public or sell the company. This also means that royalty investors are not concerned about executive compensation and retirement plans and other executive perk benefits, which reduce reported profitability and can adversely impact immediate market valuations.
So, royalties are better for the investor as they produce continuing and immediately calculatable distributions, irrespective of the reported profitability of the company. There are also significant investor protections in the royalties we recommend.
So, royalties are also better for business owners believing their company will be worth more in the future, especially with the expansion made possible by the additional capital paid for the royalty. Also, owners will not have the burden of investors, who only bought stock with the intention of selling it and who are therefore focused on reducing overhead cost and creating liquidity as soon as possible. Because the royalty is terminable through redemption the owner can use the proceeds of a sale, additional financing or public offering to enjoy the benefit of being in greater control of the company’s and his or her destiny, than had the company’s growth been financed earlier by the sale of shares.
Arthur Lipper, Chairman
British Far East Holdings Ltd.
+1 858 793 7100
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