In the past entrepreneurs started companies without having an “exit” strategy. They believed that the business would continue to grow for as long as customers benefitted. They also believed that owning and managing a successful company was their desired life’s work.
Currently, many companies are started with the intent to sell them once there is an ability to project significant growth and future profitability.
Therefore, the financial focus of those founders should be to find corporate funding necessary to reach the point of exit, while retaining as much ownership of the company as possible.
Debt is not usually available to early stage companies, and selling stock is counterproductive, if maximum ownership retention is the objective.
The company’s sale of a percentage of future revenues, a revenue royalty, is the best approach to funding, if the royalty can be terminated by a pre-payment. This can be accomplished through an issuer’s right of royalty redemption being a part of the royalty agreement. The amount of the payment should be a multiple of the investor’s cost of the royalty, less the accumulated amount of the royalties already paid to investors, within the stipulated redemption period.
Of course, at any time, the issuer of a royalty can negotiate with the owner of the royalty in an effort to repurchase the royalty. In such a negotiation cash, notes, and/or equity can be proposed by the would-be buyer of the royalty. The essence of the redemption right relates to the ability of the issuer to obtain investor acceptance of the early termination amount of the previously agreed longer-term royalty.
The negotiated terms of the royalty will take into consideration the company’s: early stage, assuredness of achievement, and cost of reaching the exit point. The cumulative amount of royalty payments made by the issuer will be credited in the exercise of the issuer’s redemption and early termination of the royalty contract.
Royalties can be based on projected revenues and our multiple website calculators are available through REX-Basic.com. However, if revenues cannot be projected then the royalty will have to be based on the investor’s minimum Internal Rate of Return (IRR) expectations. We can structure a royalty to provide at least the minimum return required by the investor, if the company is successful.
Therefore, those who are founding companies, with an exit strategy in mind or with a hope of being acquired, perhaps even before becoming profitable or cash flow positive, are best served by selling a redeemable royalty, rather than selling shares which dilute ownership and which restrict management decision-making.
The whole point is that, the company can be financed through non-equity diluting royalties, in which case, the founders do not have to lessen their interest in the company in exchange for funding. Provided the company is successful, and is able to repurchase the royalty, the founders can have a much more profitable exit, compared to that of giving equity for funding at an earlier stage. Those really believing in their ultimate ability to eventually sell the company for a value representing future success, will regret their having lessened their ownership interest in the company. by having financed the company through the sale of non-recapturable equity.
The royalty issuer has to be able to prepare and justify projected revenues for a couple of years, after which it will be able to suggest reasonable Compound Annual Growth Rate of revenues for the balance of 10 or 20 years. It must be remembered that the royalty rate will be higher for shorter term contracts.
For more information read “Revenue Royalties” and “Off the Top”, both available at amazon.com in eBook and print formats and check out REX-Basic.com and My Journal at arthurlipper.com, or just contact me.
Arthur Lipper, Chairman
British Far East Holdings Ltd.
+1 858 793 7100
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