Of course, those investing in, rather than creating, companies do so primarily, if not only, in the hope and expectation of making a substantial profit on exiting. The only difference is the investor’s desired holding time period. Most will believe that sooner is better, for those looking at multiples of cost having the highest Internal Rate of Return.
Therefore, investors will pressure company managers to do whatever will allow for the soonest IPO or sale of the company, irrespective of what is in the company’s or founding shareholders’ best interests.
In many companies affiliated with universities, the research which, if successful, results in a product that can be sold or licensed will then enable a sale of the company. The longer the development takes the greater the investment necessary before there will be either revenues or a buyout bid. Therefore, there is a natural investor reluctance to fund more than a research budget necessary to create a proof of concept sample, as additional financings are likely to be increasingly equity dilutive.
Similarly, exit-focused investors are reluctant to fund often necessary marketing programs, as they believe the job of the company has been to create a believable product which will elicit an acquiring bid from a company having the marketing ability.
The role of many CEOs requires them to be continually involved in the fund-raising mode and this is heightened by exit-focused investors wanting out, as they only got in with a view to getting out.
In comparison, investors that buy royalties from an early stage company are longer-term focused and want the company to generate increasing revenues, in which they expect to participate. Royalty investors do not have leverage with the managers of the company selling a royalty. The royalty is a contract entitling an agreed percentage of agreed revenues during an agreed period. Royalty investors are not concerned with reported profitability or company valuations. They simply want the company to be sustainable and to generate increasing revenues.
If there are alternative means of financing the company founders of startups should only sell equity if they can do so at valuations believed by them to be much too high. I don’t take seriously predictions of valuations vastly higher than that of my acquisition cost, if I am being told that my cost is but a small fraction of the exit value I will likely receive. Of course, this is exactly the pitch usually made for risky deals.
The royalty approach is one where if the company reaches the point of generating revenues it is likely the royalty investor will have a positive result. This comes from the cumulative value of the royalty payments commencing upon the receipt of revenues and also the royalty being redeemed by the issuer or being bought by other investors.
Companies issuing royalties should require in their negotiations a right of redemption and negotiate the terms of exercise of that right. We suggest the minimum redemption be a multiple of investor cost, less the royalties received. We suggest something like 5 times royalty cost, if within five years and 10 times if within ten years. This would be at least either a 38% or 26% Internal Rate of Return depending on the amount and timing of receipt the cumulative royalties already paid. Therefore, it is likely that a substantial part of the required redemption amount will have already been paid and only the differential will need to be paid in the exercise of the redemption right.
The founding shareholders are better off issuing a redeemable royalty for the early-stage money they need rather than selling dilutive shares, which in many ways will restrict them and lessen the benefits of ownership.
Arthur Lipper, Chairman
British Far East Holdings Ltd
858 793 7100
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