“What’s fair?” is the overall question facing those structuring the terms of an offering. If the terms overly favor the investor, the company’s outlook will be seriously impacted. If the terms are too good for the company receiving the investment, it is less likely the funds will be available.
Although the managers of other people’s money accept the likelihood that some of the investments in early-stage companies will result in a loss and that losses are a part of seeking higher returns from portfolios, those investing their own money are less sanguine about losses. Therefore, I recommend using royalties, instead of equity-related securities and then structure different terms for before and after an investor’s recapture of the amount invested.
The terms of the royalty can be that the royalty investor be paid a minimum quarterly amount until an agreed amount has been paid, with a purely revenue-based royalty commencing thereafter.
The committed payments should result in an investor’s recapture of investment in no more than 60 months. However, the terms of the royalty should be such that it is in both the investors’ and royalty issuing company’s best interest for the revenue-based royalty to commence as soon as possible. Executive compensation levels and restrictions on changes in company ownership can be tied to the amount of royalties paid.
The royalty rate once the investor has recaptured their investment is negotiable and the results of estimated revenues, profits and market valuations are all included in the REX-Basic template www.rex-basic.com. I believe that a fair Internal Rate of Return (IRR) for royalty investors’, after they are risk free, is more than 25% annually. Of course, this depends on both the nature of the company and the revenue levels achieved and projected.
Royalty investors are enjoying a return of funds long before equity investors receive any payment from the company in which they invested. Also, it is likely that underwriters of additional financings or possible acquirors of the company will require the royalty to be eliminated and that is why issuer rights of redemption at multiples of investor cost are included in the terms of royalties I recommend. It is also likely that royalty issuing companies, especially if they become publicly traded, will seek to acquire outstanding royalties, as the amounts being paid in royalties would be multiplied by the price/earring ratio in the price of the shares.
Finally, if the founding entrepreneurs truly believe in the future value which will be created by the success of their enterprise, they must be appreciative of their personal benefit in avoiding the equity dilution typically required by early-stage company investors. If they do not wish to avoid such equity dilution, then their optimistic projections should be questioned.
There is lots to be gained from reviewing the writings in my blog Journal arthurlipper.com and in the samples provided in each of the :www.rex-basic.com templates. Please contact me with questions.
Arthur Lipper, Chairman
British Far East Holdings Ltd.
Del Mar, CA 858 793 7100
arthurlipper@gmail.com
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