Business owners frequently want to grow their companies faster than retained earrings permit.
Many business owners who believe in an increase of the future value of their company and who also enjoy the perks of ownership, do not want the burden of outside shareholders.
Experienced business owners are leery about long term commitments which can impede company actions or are unnecessarily profit reducing.
For these reasons and in order to encourage business owners to use revenue royalties in the financing of their businesses we recommend the inclusion of an issuer’s right of redemption, permitting the issuer to exercise a right to repurchase the royalties the company has sold on pre-agreed terms.
The redemption right enables the royalty issuing company from the outset to know the worst-case cost of terminating the royalty that raised the investor capital used to grow the business.
Redemption rights are similar to prenuptial marriage agreements because they specify the terms of separation. Of course, royalty issuing companies can always negotiate directly with the investors to whom they have sold royalties. The companies can also make tender offerings to all of the royalty investors. There are several possible variations of tender offers which may be made. Tenderers can offer cash, debt, equity, warrants or combinations of these assets.
Tenders can also take the form of a Dutch auction, where the tenderer establishes the amount of money available to buy whichever royalties are offered at a stipulated price. If there are still funds available from the amount initially offered a subsequent offering can be made at a lower price. Therefore, royalties sold in the first tender, at the earliest point in time, get the higher price. As the tenderer’s intent to reduce the terms in subsequent bids is made known there is an incentive for possible sellers to accept the initial and higher offer.
Royalty issuing companies are likely to want to redeem all of their outstanding royalties in the event of a pending financing, a public offering of their securities, the sale of the company or just because they have the ability to finance a transaction which will reduce obligations that lower their profitability.
The tender valuation is calculated at a level which enables the issuer to redeem and therefore terminate the future revenue sharing obligation of the royalty, and the revenue level and projected trend of revenues determine the value the tenderer will pay for the royalty.
If direct negotiations or tenders do not result in the termination of all of the outstanding royalties, the issuer may exercise this pre-agreed redemption right. We believe that most successful companies will for many reasons elect to exercise the right of redemption and that only a few longer-term royalties will remain outstanding until the maturity of the contract.
The terms of redemption are stated as a multiple of the value paid by the investor for the royalty, less the amount of royalties already distributed by the issuer to the investors. The right is exercised at a cash price that is lower than the multiple due to previous royalty payments. Specifically, as an example, if the agreed redemption value was 5 times the cost of the royalty, if exercised in 5 years, the company would have to pay the investor the difference between 5 times the cost of the royalty, less whatever had already been paid. There could also be a right to redeem the royalty within 10 years for 10 times the investor’s original cost of the royalty, less the royalty payments made.
It is also possible that royalties paid earlier will be more highly credited against the required multiple than those paid later and will have a greater percentage value as a credit of the amount discounted from the required redemption payment than the later payments.
For example, royalties paid to investors can be credited against the amount owed as an additional payment for a redemption within an agreed period. However, the time value of money can be reflected in an annual credit discount as royalty payments received earlier in the payment period may be more highly credited than the more recent payments, due to the income which can be earned on the reinvestment of the amounts received. If there was an agreed 5% annual money value, a payment credit discount of the payments received might be as follows:
Year 1: 0%
Year 2: 5%
Year 3: 10%
Year 4: 15%
Year 5: 20%
Year 6: 25%
Year 7: 30%
Year 8 35%
Year 9: 40%
Year 10: 45%
All years after 10 years will be credit discounted until there is no credit as an offset to the required redemption payment.
Since both the issuer and investor understand the terms of the royalty it is always possible that different terms could be negotiated, perhaps involving the acquisition of stock in the issuer’s company.
It is the terms of termination which can determine the appropriateness of using royalties to finance businesses, and it is so much easier and better for a company to get into a financing deal if the worst-case cost of early termination is known from the outset.
Arthur Lipper, Chairman
British Far East Holdings Ltd.
+1 858 793 7100
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