“How much do you spend on R&D? Is it enough?” is a question raised by Dave Berkus berkonomics.com/?p=3865 in his weekly Berkonomics blog. Dave’s subtitle is ” Why do profitable, mature businesses die away?”
As I use, as an example of how the terms of a royalty can protect investors, even when revenues do not rise to expected levels or even decline, I thought the following is appropriate.
First, company’s customers are the best source of early information regarding competitive products. Customers are constantly seeking better pricings and products or services. The quality of a company’s relationship with its customers should be such that they will be responsive to questions about new and perhaps more attractive possible offerings. Customer failure to renew or cancel orders should not be the first indication of an aging product or deteriorating customer relations.
Next, assuming that additional funding is necessary for the development of new and better products or services by an established company, there is an alternative to incurring debt or sharing ownership by selling stock. The alternative is selling a royalty. A royalty is an agreed sharing of a percentage of defined revenues. during an agreed period and on agreed terms.
Royalty investors seek levels of return which are good and will get better as the defined revenues grow. However, the royalties we recommend are redeemable by the issuing company on negotiated terms and do not require any dilutive sharing of ownership.
It is the flexibility of royalties which makes them so attractive to both investors and issuers. Following are possible terms for a royalty, for which investors might pay $5.0 million. $5.0 million is the assumed amount necessary to make significant improvements or replace company’s primary product. If the amount necessary is either minor or simply a pricing issue, the additional funding is unlikely to be necessary.
Defined revenues can be; geographic, product specific, a percentage of revenues applicable for periods determined by the cumulative amount of royalties paid to investors, partially from overall company revenues and partially from newly developed products.
The royalty payment period can be 20 years or less, bearing in mind that the longer the period the lower can be the royalty rate. Also, royalty issuers should have a right of redemption, to terminate the royalties on agreed terms, including the amount of royalty payments made prior to the redemption. Possible royalty redemption terms can be five times investor’s cost, within first five years and ten times within second 5 years. Five times in five years is a 38% IRR and ten times in ten years is a 26% IRR. However, the Reinvested Royalty Rate of Return (RRRR) will be significantly higher than the IRR. Such terms are negotiated prior to the sale of the royalty. Of course, royalty issuers and others, can and likely will, attempt to buy the royalties from the royalty investors on whatever terms are agreeable to the parties.
The royalty issuing company can, as a risk-shifting justification for negotiating a lower royalty rate, agree to make a minimum level of periodic payments, until a target amount of royalties has been paid. Of course, the royalty rate can be agreed to be modified once the minimum amount of payments have been made.
Experience and using our web calculators are necessary to optimize the inherent flexibility of royalties. The newly modified and vastly improved REX-RIAR.com (Royalty Issuer Assured Return) will ultimately become an investment industry standard, as so many of the possible features of royalties can be used.
The REX-RIAR.com website also introduces the concept of “Credited” royalties, where, for an increased royalty rate and other terms, the royalty issuing company retains the royalties for an agreed period, rather than making royalty payments at the time of revenue receipt, as required in the case of “Distributed” royalties, which are distributed to investors quarterly.
Royalties are the better way of both investing in and financing of privately-owned companies, especially established companies having specific need to develop additional new revenue producing products.
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