Contracts Required in Royalties

There is a significant amount of work for an attorney, both in advising client investors considering the purchase of a royalty and of royalty issuing companies seeking to attract non-equity dilutive capital.

Following are two articles Revenue Royalties which I am annotating in bold for the purpose of providing some later thoughts and intended to add reader value.

Contracts Required in Creating and Managing a Royalties Income Fund

Fund creation depends on the form of legal entity to be used raising and managing the capital with which it will buy royalties from privately-owned companies. If there is to be an independent management company then there must be a contract between the investing and managing entity.

Due to the nature and U.S. tax treatment of royalties, either a Limited Liability Partnership (LLP) or (LP) might be better than an LLC for a royalty income fund. These are matters to be discussed with the attorneys and accountants advising those establishing royalty income funds.

The investing entity and the company issuing the royalty must have a private placement memorandum (PPM) describing the company seeking investor funds.

It is important that the use of proceeds be sufficient to achieve revenue levels assuring reported profitability if the company is likely to need additional capital for further growth, as the presence of a royalty will be problematical for both lenders and equity-related investors. This is the reason for allowing issuers a right of redemption terminating the royalty. The multiple of investor’s cost, less royalty payments made, are part of the royalty agreement.

The PPM should include a copy of the form of royalty agreement describing the terms of the relationship between the royalty income fund and the royalty-issuing companies.

A subscription agreement must also be created and included as it is through the use of this agreement that funds are transferred from the investor to the royalty income fund.

It is far simpler if all of the investors in the fund are “accredited,” as that term is defined by the SEC.

There must be a contract with the asset holder, royalty issuer, and agent of the investors regarding the actions required of the asset holder if there is a default in the royalty agreement.

The issuer-contracted asset holder must be satisfactory to the investors and is trustee-like. It is possible the asset holder be the law firm of the royalty issuing company. The asset holder grants the royalty issuing company exclusive, international rights to use the assets without cost for so long as the issuer is in compliance with the obligation to pay the investor’s agent royalties as agreed. The purpose of the asset holder process is to create a portfolio of assets beyond the reach of creditors, without which the issuer cannot be in business and which will be necessary and available for a continuation of the business with a royalty by the to be reorganized company to the asset holder representing the investors.

The relationship between the members of the royalty income fund and the managing members must be defined and documented.

Also, there will be contractual relationships between the consultants to the fund.

The royalty issuer will, as a part of the royalty agreement, provide the investing entity with a 60-month “continental” put (exercisable at, not until, maturity) at the cost of the royalty, less the cumulative value of the royalties paid to the investor. The put is only exercisable at maturity. The put is in effect a money-back offer. However, it would not be in the investors’ best interest to exercise the put if the difference between the cost of the royalty and the amount paid was minor if the company was generating revenues and therefore royalties. Also, as the royalty entitlement is for a much longer term than 60 months, it is probable that others will pay a premium for the present value of the royalties reflecting the projected revenues of the issuer.

There is also a redemption right, which is effectively a call permitting the royalty issuer to buy the royalty from the investor at a known redemption valuation. The valuation will be a multiple of the cost of the royalty and therefore result in an excellent investment for the investor.

The issuers will also be required to obtain from British Far East Holdings Ltd. an annual patent license fee for .50 basis points or half of one percent of the total amount received from the royalties issued.

The fund’s attorney will also be required to review the royalty agreement as negotiated with the royalty-issuing companies.

The attorney of the royalty issuer will be required to affirm that the royalty-issuing company is in good standing and has no material non-disclosed outstanding liabilities, including possibly adverse results of pending litigation.

As part of the investors’ due diligence process, a range of documents will be required to be provided by the royalty-issuing company. The respected legal publisher FindLaw refused us permission to reprint their extensive list of due diligence items they recommend in buying a business. They do not seem to have anything directly relating to royalties, and the needs of a royalty buyer are different from those of a business buyer. However, if an individual copied the list from FindLaw and sent it to me I could in good conscience indicate which of the cited items seems to me to be unnecessary for an investor considering the purchase of a royalty from a royalty issuing company.

Protecting the Interests of Royalty Investors

Believing that security is best achieved by exploring the points of royalty issuer discretion and other areas of weakness, we focus on possible problems and solutions.

Projection of Revenues and Therefore Royalty Payments

Prediction of revenue trends, though easier than that of estimating future earnings per-share as is necessary in equity investing, is still an exercise requiring industry and competitive factors as well as corporate strategy and financial and executive capability.

If the maker of the projections is marketing oriented, the result will be different than if the maker is a chief financial officer or an executive with a law or accounting background. In any case, revenue projections should be viewed with a professional investor’s typical skepticism.

Royalties can be structured to penalize the royalty issuer if projected revenues fail by an agreed amount. The royalty issuer can also be benefitted if the revenues, and therefore royalty payments, are better than projected.

The REX proprietary website calculator facilitates the use of a carrot and stick approach.

Royalties can also have minimum royalty payment obligations. They can have a rescission clause requiring repayment of the amount paid for the royalty, including the royalty payments paid to royalty investors, at the end of an agreed period.

The proprietary website calculator using minimum Royalty Issuer Assured Returns is

Enforcement of Obligations

Royalties can have critical assets of the royalty-issuing company transferred to or liened by an agreed party which acts like a trustee or escrow agent. The party controlling the critical assets will allow the company to use the assets exclusively and without cost (except for required maintenance) so long as the company is in compliance with the terms of the royalty payment agreement. At the end of an agreed period and after the fulfillment of royalty issuer obligations, the assets will be returned to the royalty-issuing company. In the cases where a loan is first made to the company, with a royalty following repayment of the loan, the critical assets of the company will be viewed as collateral. This asset holder approach is discussed above.

Royalty-Issuing Companies Not Revealing All Income

In the practice recommended by Pacific Royalties, the controlling shareholders of the royalty-issuing company personally attest that all revenues of the company and any affiliated companies are deposited in banks approved by the royalty investors.

Again, as recommended by Pacific Royalties, the royalty-issuing company issues irrevocable instructions to the designated banks to withdraw the agreed percentage from each deposit, remitting the withdrawn amount to the account of the royalty investors.

In the event the royalty issuing company is not able to make satisfactory arrangements with an investor approved bank there are other ways of accomplishing the same result of investors receiving an immediate payment on the issuer’s deposit of revenues

It is relatively easy to do discovery of the principals of the royalty-issuing company, and look for hidden relationships. Employees, competitors, and customers would all be sources of intelligence with their own reasons to assist the royalty investors in their quest for contractual compliance.

Can Royalty Investors Lose Money?

Of course, royalty investors can be disappointed in their returns and even lose money. Revenues not approaching the projected levels can cause disappointment. This can be due to the products or services of the royalty-issuing company not being found attractive by the market. The poor revenue generation can be due to price or competitive factors. It can also be due to mismanagement of the company.

However, as long as there have been some revenues, the royalty payments will have reduced the amount of principal invested in the company. If the company survives more than a few years, most of the amount paid for the royalty should have been returned to the investors.

Of course, in any investment project there is the possibility of loss. However, we believe that royalties, especially when combined with debt, are the very best means of achieving superior risk adjusted returns.

Because, the use of royalties in the financing of businesses is a new approach there are not the usual law firm, word-processor stored, contracts which can be readily used and there has to be original drafting and negotiations for the required relationships. There have to be all of the normal incorporation’s documents, employment agreements, etc. There also have to be agreements between the company and the investors as to the royalty agreement, including the terms, agreements with third-party asset holders, advisors and personal Attestment of controlling shareholders regarding the deposits of revenues and other agreements unique to royalties. This is why attorneys and business advisors should devour contents of Revenue Royalties. See

Arthur Lipper, Chairman, British Far East Holdings Ltd.

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