What and How to Negotiate in Royalties

Royalties and their contractual terms are negotiable between the issuer and investors. Since royalties are contracts, they can be changed with the approval of the parties. Following are many, but not all of the terms which can be negotiated in the process of allowing the use of the investor’s money by the royalty issuer.

AMOUNT: The royalty issuer typically has a specific need or desire for an amount of money, presumably in order to increase the revenues and/or profits of the company. The investor should be comfortable that the amount of money being sought is both offered on sufficiently attractive terms and is adequate to attain, without subsequent financing, the clearly specified objectives of the royalty issuing company. The amount sought should be reasonable in terms of the prospects for the company and the revenue growth projected. Investors should really understand if the amount being sought is justified by the predicted improvement in the company’s prospects.

It is also possible the investment may be staged, with agreed demonstrable achievements being required for additional tranches of investment.

ROYALTY PAYMENT PERIOD: The royalty is a contract for the payment of a percentage of defined revenues to be paid to investors during an agreed period. Usually, the longer the period of revenue sharing entitlement the lower can be the royalty rate. Professional investors usually have overall portfolio rate of return objectives and therefore want to continue participating in growing levels of revenue for as long as possible. However, as every dollar paid in royalties could be a pre-tax dollar if not paid, the business owner logically wants the profit burden to be as short a term as possible. Therefore, the contractual period becomes one of the most important terms negotiated between the patties.

In the case of royalties, we recommend that there is a right of redemption clause permitting the owner to terminate the royalty by paying an agreed amount within an agreed period, including a credit for the royalties already paid. If it was agreed that the royalty could be terminated within 5 years at 5 times the investor’s initial cost of the royalty the annual Internal Rate of Return (IRR) would have been 38% and if 10 years was the period and 10 times the original cost, less the royalties paid the amount, the IRR would be 26%.

However, as recently described in another writing, the Royalty Rate of Return of RRR would have been even higher based on the reinvestment of the royalties received.

Royalty issuers can also, at any time, attempt to negotiate a repurchase of the royalty by direct negotiation with individual investors or through a tender offered to all of the royalty investors. The tenders can be for all of the outstanding royalties or for only the royalties which can be acquired for a fixed total amount. This is called a Dutch Auction and results in the investors competing for inclusion in the purchased number of royalties by adjusting the price at which they would sell.

There will have to be an agreement that if X percent of the royalty investors accept the terms of a tender that all investors will be required to do so as holdouts seeking benefit can be damaging to all other concerned parties.

Investors wishing to sell their royalties will find the royalty issuing company the most logical buyer and the website calculator REX-PV.com can calculate the premium which will have to be paid for their royalty to provide the IRR they seek. The Present Value calculator also shows the return the buyer would receive in the event the projected revenues for the remaining period of royalty entitlement were achieved. Presently the calculator shows the IRR results, but will in the near future also show the RRR results, based in both cases, on projected revenues and therefore royalty payments having been made and those which will be received.

It is also possible the parties could agree to either or both caps and/or minimum royalty payments and that such agreements could use the royalty payment period as a means of achieving the desired result. The term of a royalty could be shortened or extended based on the amount of royalty payments received in agreed periods. A royalty issuer might propose that if the investor received X multiple of cost in Y period the royalty would be shortened by Z years or be extended for a number of years if the royalty payments failed to reach an agreed cumulative amount.

ROYALTY RATE: The percentage of revenues can be for the entire period in which the payment is required. Royalty rates can also be changed for different periods based on amounts of royalties paid within prior periods. For instance, If the amount originally invested triples in royalty payments during the first 5 years there could be a 20% reduction in the royalty rate for the next 5 years and if there was another tripling in the next 5 years the royalty rate in the following period could be reduced by 30%.

In the website calculator REXScaledRoyalties.com the parties agree that if within a Selected Adjustment Period (SAP) the revenues exceeded the projected level that there would be a subsequent reduction in the royalty rate.

The approach also can be used to penalize the royalty issuer, so if the revenues fail to be achieved within the SAP by an agreed amount a penalty would be imposed. The penalty could be a requirement of payment of the differential by note or installment or an extension of the royalty payment period or whatever is acceptable to the parties. The purpose of this approach is to encourage royalty issuers to be extra conservative in their revenue projections as the Carrot and Stick terms of the contract should be meaningful.

OTHER NEGOTIATION POINTS: The investors and the royalty issuing company must agree, using our approaches, upon a choice of the bank(s) into which all revenues must be deposited and the terms of either the bank or an acceptable third-party deducting the appropriate royalty rate for the investors.

Again, using our approaches, the company must transfer or assign to a mutually agreed third-party the control over the company’s critical assets. The asset holding party grants the company the international, exclusive right to use the assets without charge for so long as royalties are being paid as contractually required. In the event of a cessation of royalty payments the license to use the assets is terminated. The purpose of this procedure is to assure that a reorganized royalty issuing company, requiring the use of the assets, will continue paying the royalty.

The amount and timing of information regarding the royalty issuer will have to be agreed. Similarly, the access of the investors to the senior and perhaps other employees of the issuer will have to be agreed. There are issues of confidentiality to be agreed.

CONCLUSION: Assuming that investors seek high and increasing returns with limited and reducing risk and that business owners seek non-equity-dilutive capital, it is logical to believe that fair terms can be developed and agreed. We are available to professionally assist either or both of the parties in the negotiation of royalties and believe that royalties are the better way of both investing in and financing privately-owned and early-stage companies.

Arthur Lipper, Chairman, British Far East Holdings Ltd.

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