Revenue royalties are based on the sales of products or services that are generated by companies which have sold a percentage of their revenues to investors for the purpose of raising non-equity-dilutive financing in order to grow their businesses.
The terms of a royalty should include a specification of the revenues from which a percentage will be deducted by the royalty issuing company (issuer) and paid to the royalty investor (investor). If not specifically defined, the issuer will be obligated to deduct the agreed percentage from the entire amount of revenues generated. The amount deducted, unless otherwise agreed, should be paid to the investor immediately upon receipt by the issuer.
The revenues tied to the royalty should be specified so that the investor and issuer are in agreement as to the base from which the percentage will be deducted by the issuer and paid to the investor. The revenues can be tied to total sales or be limited to sales: in limited geographic areas, within defined time periods, from all or specified products or services, and subject to amounts already paid to the investor. It is also possible that the royalty payments can be calculated differently for certain customers of the issuer.
The royalty can be based on all of the revenues of the issuer or simply on the growth of revenues occurring after the point that the investor has purchased and paid for the royalty.
The timing of the royalty payments by the issuer to investors can also be made over delayed periods, if so agreed. The requirement for immediate payments is recommended primarily to ensure that investors will be paid ahead of the issuer’s other obligations.
If specific and unique payment terms are added to royalty payments it will become less likely that a bank will agree to administer a revenue-collection lockbox arrangement. Therefore, investors will most likely require that banks notify them of revenue deposits and that issuers at the same time advise them of the amount and details of the royalty payments made to the investors’ accounts.
It is also reasonable that investors should either rebate or provide a credit to the issuer for any amount refunded to the issuer’s customers.
To further induce investors to purchase the royalty, the issuer could also assure investors that at the end of an agreed period the investors’ cost of the royalty will have been returned in the form of royalty payments or otherwise. Therefore, the issuer has a contingent liability to return to the investor the difference between the amount paid for the royalty and the amount received in royalty payments up to the end of the agreed period. This money-back offer of the amount paid for the royalty is an option and should be found attractive by investors. The contingent liability of the money-back offer may allow the issuer and their financial advisors greater accounting discretion to determine when to recognize the amount of incremental income resulting from the sale of the royalty. In early-stage companies the recognition of the royalty payment as being connected to income should not be problematic due to offsetting expansion-related loses. Royalty payments by the issuer to investors are income tax deductible to the issuer and tax free to the investor until the payments equal the amount invested and thereafter are considered ordinary income, similar to dividends.
It is also possible that investors will prefer that an independent entity will guaranty the investor’s principal by the end of an agreed period. There will likely be a guarantee fee which will have to be paid by the issuer to the guarantor at the closing of the transaction.
Royalties are an alternative means of financing businesses. They come with associated expenses that may be less burdensome to business owners than the repayments and restrictions of borrowing or, most importantly, the sale of equity. Business owners who believe that the future value of their enterprise will be far greater than its present value should immediately appreciate the attractions of the sale of royalties as a means of financing. It is likely that the royalty will be redeemed by the issuer on agreed terms in the event the company is acquired or decides to engage in a new financing.
Issuers will also wish to redeem outstanding royalties when successful because every royalty payment is a pre-tax profit deduction. Therefore, the negotiation of the terms of the issuer’s redemption right is one of the most important aspects of the contractual relationship.
Both issuers and investors should be professionally advised by their attorneys and accountants regarding the use of royalties and any of the statements made above. There is an annual patent license and advisory fee of 50 basis points of the amount raised by the issuer–which will be paid by the issuer. We welcome the opportunity to advise both investors and issuers regarding the use of royalties and the structuring of royalty agreements.
Arthur Lipper, Chairman
British Far East Holdings Ltd.
+1 858 793 7100
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