Ok, so you are an entrepreneur and have decided that your early-stage company will be really successful and increase in market value over the next 5 to 10 years. Therefore, you recognize that retaining as much of the ownership of the company as possible is a primary objective, in the process of funding the company’s growth. Therefore, raising the necessary financing by selling a revenue royalty, rather than stock in the company, is in the best interest of everyone concerned.
First, not all companies are good prospects for using revenue royalties (royalties) because their success is uncertain or the projected profit margins are too small. The professional investors who will consider buying a royalty from your company have concerns about you and the ability of executives to manage the company so that it becomes cash flow positive in a few years after being financed. This means that they will need to be convinced that you have identified customers for the products you produce, and that they will pay the price you will be asking. The research which investors will expect that you have done and will share with them includes the activities of competitors, and the economic environment facing the hoped-for customers. The bottom-line is that investors will want you to project minimum annual revenues so that they can negotiate the royalty rate (percentage of defined revenues) and other financial terms that your company will be paying the investors.
The royalty investors will only be interested in the level and timing of revenues the company will generate, as they will not have any ownership interest in the company. If you follow our recommendations, an Issuer’s Right of Redemption (RR) will be included in the royalty agreement terms. The RR can allow an early termination of the royalty payment obligation upon the cumulative payment of royalties within a given period. Since additional funding, and/or the company becoming involved in being acquired or merging with another company, will probably result in a required termination of the royalty. Therefore, it is much better for the issuer that the terms of the RR be understood at the outset. In the case of a RR, since investors will be denied the benefit of the royalty continuing to maturity, they will therefore want a satisfactory total return. For early-stage companies, we recommend a RR requiring the cumulative payment of 5 times the investor’s cost of the royalty, if received within 5 years, and 10 times if in 10 years. The 5-year deal results in more than a 38% Internal Rate of Return (IRR) and the 10 X in 10 years is more than a 26% IRR.
If an investor also has a social-impact objective of contributing to a specific community, a royalty additionally facilitates the development and growth of the community nearby the company issuing the royalty, The investment will result in the payment of wages, the training of staff, health and retirement programs, the payment of rent or construction, and the payment of a range of taxes. The community thereby will have a company doing good for itself and for the community.
We hope to assist companies in structuring royalties as well as helping those issuers in explaining the benefits of royalties to investors.
Arthur Lipper, Chairman arthurlipper@gmail.com
British Far East Holdings Ltd.