Royalties are all about receiving a superior amount of income while bearing a reasonable amount of investment risk.
We have described a process for creating revenue projections which can be found in the arthurlipper.com royalty Journal section about projecting a Pre-Revenue Company’s Revenues. So next we need to determine the terms of royalty that will be attractive to investors.
My suggestion is that royalty issuers should first interest the prospective investor in the scope and assuredness of the project, in the case that it is adequately funded. Then ask the investor what they believe is a good return, in internal Rate of Return (IRR) terms, assuming there was also significant risk, as well as a significant potential reward, for what you believe to be reasonably achievable.
Using our website calculators, all we need to begin designing a royalty is the investor’s target IRR for either a 20- or 10-year royalty payment period in order to create a proposal using the projected revenues. The longer the royalty payment period the lower can be the royalty rate necessary for reaching the investor’s target IRR. The issuer’s estimated net after tax profit margin and the price/earnings ratio of comparable publicly-traded companies permit added dimension for the analytics.
Keeping it simple, let’s use REX-Basic.com and assume that in the first year of the royalty payment period the projected revenues were $2.0 million, with a CAGR of 50% for the next 4 years, then 30% for 5 years and 20% for the final 10 years, the amount of money necessary was $5.0 million, the NAT over the course of the period was 10%, the comparable company P/E 15 and the investor’s target IRR 15%.
The data entry and analytics table as following show the results, using a 5% royalty rate for the entire 20-year period, if the projected revenues were achieved, the target IRR would be also be achieved in the 15th year, increasing to an IRR of 20% in the 20th year. If the royalty rate had been 10% in the 6th through the 10th year the 20-year IRR would have been 22.6% and the 15% target would have been achieved in the 111th year.
I structured the following REX-Basic.com website calculator using a combination of data which would result in a 20-year IRR of 20%. The User Name and Password are “Sample”. Please make no changes in the Sample data, as the whole purpose of the exercise is to demonstrate the calculator’s workings and flexibility. Clearly, the data used is not intended to be reflective of any current situation. You are, of course, invited to sign up and create your own scenario and test data. Be sure to click “Submit” whenever you make any change in the data you wish saved. If you have any difficulty in using REX-Basic.com contact me.
The art of designing royalties which meet the needs of both investors and issuers is facilitated by our 4 different REX approach website calculators. Once practiced, using these calculators is easy and the elements can be modified with the results immediately presented.
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Arthur Lipper, Chairman
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