Negotiating a royalty with a company seeking equity funding

Many of us receive unsolicited investment pitches to invest in the equity of startup companies, which might be of interest due to their claimed potential.

Since I believe that revenue royalties are the better way of investing in the anticipated success of all non-publicly traded companies, the following dialogue is presented as a possible guide for those investors having the ability to provide all of the funding sought.

Entrepreneur: Because of what we have just presented we believe that an investment in our company will be highly advantageous to you.

Investor: Based on the information provided I might, after doing some due diligence investigation, be interested in providing the funding you seek. However, I am only interested in investing in the revenue of the company and not the stock of the company.

Entrepreneur: But, what we are offering is shares in the company, an ownership in which could become a very valuable asset.

Investor: I understand that you are currently hoping to sell me shares at a price you believe will be a small percentage of what they will be worth once the company has revenues, and is successful. However, I only want to invest in the revenues, and not speculate on the possible valuation of the shares at some time in the future.

Entrepreneur: So, how would that work? Does it mean we keep all of the ownership of the company?

Investor: Yes, it’s called a revenue royalty, and you and your associates keep the ownership of the company, and those providing the capital you seek get an agreed percentage of the revenues of your company.

Entrepreneur: Ok, the company is projected to have a high profit margin and rapid growth of revenues. Certainly, our keeping the ownership is very appealing, and due to our profit margin, we can afford to pay out a fair percentage of the revenues.

Investor: Ok, let’s say the royalty rate is10% of revenues until we get 3 times our money back and then drops to 5% of revenues until we get another 3 times the amount we paid for the royalty, after which we get 3% of the revenues to the end of the royalty payment period.

Entrepreneur: How long is the royalty payment period?

Investor: 20 years.

Entrepreneur: That’s too long a period and we want a shorter period.

Investor: Ok, but if our royalty is for a shorter period we will need to improve the terms and the royalty rate needs to be higher in order for the issuer to shorten the periods of payment. In general, due to the risk of the revenues being less than you are projecting, we need a higher amount of revenue participation for longer periods to receive the Internal Rate of Return (IRR) we consider fair for the total risk of capital we are accepting.

Entrepreneur: What if we reduced the risk by providing an assurance that you would not lose the money invested?

Investor: That would certainly be attractive as we would still have the upside and will have reduced the downside. Of course, the assurance would have to be made by a credible party. The improvement in the risk/reward ratio would justify a modification of terms.

Entrepreneur: What if we want to sell the company or go public? Can we terminate the royalty?

Investor: Yes, but it depends on when you exercise the right of redemption that we recommend as a part of the royalty agreement. Let’s say, for example, that if you do so in 5 years that you will agree to pay us 5 times what we paid for the royalty, less whatever amount you have already paid you in royalty payments and 10 times if in 10 years, less an agreed percentage of that you already paid us in royalties.

Entrepreneur: Ok, that seems fair as we would only be paying a premium for terminating the royalty if good things were happening to the company. What are any other terms?

Investor: We need to have mechanisms for collecting the agreed royalties whenever the company receives revenues. We also want to have an optional company repurchase agreement that at the end of 5 years we can get all of our original investment back, less whatever has already been paid. We will need independently audited annual revenues, and possibly a full audit.

Entrepreneur: If we are able to honor a repurchase option at the end of 5 years you would not ever exercise the option, giving up the remaining years of revenue participation. Right?

Investor: Yes, that is correct, but there are good reasons for this requirement, and it is really in your best interest.

Entrepreneur: How long will all of this take?

Investor: Probably 60 to 90 days after we agree to the terms and we have completed our study of the investment opportunity. Your attorneys will have to review the documentation our attorneys will create. The company will pay, at the closing of the transaction, all of our directly attributable expenses relating to the funding.

Entrepreneur: So, we negotiate the terms of a deal before you reach a decision to invest and we pay for the expenses of your due diligence and legal fees, if there is a deal? Do we have to agree to do the deal if we find other funding possibilities within the period of your deliberation?

Investor: That is correct. We have no deal until we decide to invest and thereafter you are no longer able to strike a different deal with anyone else. It’s like having to cease dating with others once you become engaged.

I hope the above dialogue has been useful for those considering investing in startups and early stage privately owned companies. Royalties are the better way of investing because revenue growth, especially if minimum royalty payments are a part of the deal, are a better measure of investor success than per share earnings.

Arthur Lipper, Chairman
British Far East Holdings Ltd.
+1 858 793 7100

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