Owner: We have a successful, closely-owned business and know that if we had some additional capital we could significantly grow our business.
Investor: We seek to earn a good and growing return on our capital and want to do so with less risk of loss than is normally associated with high return investments.
Owner: That’s fine for you but we don’t want to be taken advantage of, as is so usual in the deals we are pitched. We are not personally guaranteeing levels of reported profit or repayment amounts of more than is achieved by the business.
Investor: Fair enough. If we agree on the terms of a 10 or 20-year royalty is the business willing to offer us the option of getting our money back at the end of 5 years, including whatever royalty payments have been made in the first five years?
Owner: Yes, if the remainder of the royalty payment obligation is also terminated.
Investor: Well, that was easy. Of course, it is unlikely we will want to exercise our option, terminating our revenue participation, if there are revenues and we are getting paid whatever is agreed on a quarterly basis.
Owner: Sure, I get it, we will have already paid you most, if not all, of the amount paid to us for the royalty, so your only residual risk is that we are not able to meet whatever the additional amount might be for us to exercise our repurchase obligation. Not much risk for either of us.
Investor: Are you willing to tell us how you plan to use the money we will pay your business for the royalty and commit to use the money as agreed? Also, will you estimate for us the revenues of the business for an agreed number of years after you have the use of our money?
Owner: Sure, as long as neither we, nor the business, is making any guarantees of the estimates being achieved.
Investor: Ok, we are making good progress. What if, as a result of our accepting that your company’s projected revenues are reasonable, we offer to purchase a 10-year royalty for the amount of capital the business needs for expansion in exchange for 15% of those revenues?
Owner: That’s a very high royalty rate and the rex-basic.com website calculator shows that you would be earning more than a fair return. We can’t do this.
Investor: If we felt more secure with the company being able to protect our capital by either transferring or pledging to an agreed independent party title to the critical assets of the company we could consider reducing the royalty rate.
Owner: I can see how that hurts us but not how it helps you.
Investor: It helps us if the terms of holding the title to the critical assets resulted in the continuation of the royalty if the company had to be reorganized or was sold. The only triggers for the holder of the assets to cancel the company’s cost-free, exclusive, international license to use the assets would be your company’s failure to pay us as agreed in the licensing agreement or a change in an agreed percentage of the ownership of your company. Our objective is to be certain that our interest in the revenues we have purchased continues for the agreed period.
Owner: Can the company get out of the deal and terminate or redeem the royalties? I can see the possibility that the existence of a royalty could be a problem in future financings, going public or when selling our company, in which we both have different interests.
Investor: Correct. The company should have a Right of Redemption and therefore be able to repurchase on agreed terms all of the outstanding royalties. The terms can be based on a multiple of the investor’s cost of the royalty and the period of holding, including the cumulative value of the royalty payments received.
Owner: Ok, but how do we agree on the terms of the Right of Redemption, especially since it is highly possible that it may become necessary?
Investor: Well, if we had the security of the company’s critical assets being held to assure contractual compliance and a redemption multiple of cost which produced a satisfactory level of return, depending on the royalty payment period being forsaken, we could reduce the royalty rate to 10% of revenues.
Owner: That’s still too high a return for the amount of money we would be receiving.
Investor: Ok, what about 8% if we made the royalty good for 20-years?
Owner: I like and understand the relationship between your target return and the risk you think you are taking. We also understand why it is better for us not to have to sell stock in the company at this time. We may never want co-owner equity investors, in our business, and certainly we would only want them at a valuation of the company after we make it bigger and better.
Investor: We can reduce the proposed royalty rate further if there can be some risk shifting.
Owner: What do we have to do and how much will it save us?
Investor: If the company assured us of receiving a minimum level of royalty payments, that would make a big difference. The assurance could be based on quarterly payments or a cumulative amount at the end of agreed periods. The royalty rate for a 20-year royalty could possibly drop to 5%.
Owner: Is that the best deal you can propose?
Investor: No, it is not. We can scale the royalty rate based on cumulative royalty payments received in agreed periods. For instance, if we have received an agreed multiple of our cost by the end of an agreed period the royalty rate could decline to 2% of what we are assuming will be higher revenue levels for the balance of the royalty payment period.
Owner: Ok, so we have gone from a 15% royalty rate on revenues, declining to a possible 2% rate down the road; and all mostly on terms which are easily met and justified if we achieve our projected level of revenues. Let’s now try to make a deal.
Investor: Great. In the end you get to retain your full ownership of the business until you are better positioned to refinance or sell it and we receive an excellent return considering the level of risk we are projecting.
Dialogues and images are effective ways of communicating concepts and we hope the forgoing negotiation highlights the relationship between possible royalty rates, the company’s cost of money and the investor’s risk-weighted expectations of return.
There are many different approaches and details for the use of royalties in the funding of company growth, but the principle remains constant. The cost of money is based on projected risk and reward, and by using our patented approaches, the risk can be reduced and the reward increased.
Our six highly useful and proprietary REX website calculators have been conceived and developed to facilitate an immediate understanding by both royalty investors and issuers of the effect of terms and term changes using our approaches. The calculators quantify the result of applying the agreed terms and conditions of the royalties to the projected revenues. Royalties are exclusively about revenues and revenue projections must be reasonable as to their likely achievement.
Arthur Lipper, Chairman
British Far East Holdings Ltd,
858 793 7100
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