Royalties – What They Are and What They Are Not

Bill, an ordinary man, with a skill in making especially tasty hamburgers, decides to open a hamburger hut. He estimates that it’s going to require about $1.0 million to open Bill’s Hut in a rented location.

Bill doesn’t have the necessary funds and no bank is interested in lending to his company, Bill’s Hut, Inc. Of course, if he or someone else, with sufficient collateral, would guarantee the loan the bank would lend Bill’s Hut the $1.0 million, but the bank would really be making the loan to the loan guarantors, as they have the full and unconditional repayment obligation.

Bill does not have the collateral and does not want to personally guarantee the loan. He also does not know of anyone who would do so.

Bill is offered the money by a high interest lender, but the terms of the loan are unattractive. Bill is also offered money by Angel investors, but only in return for a large percent of Bill’s Hut ownership. Bill doesn’t want to have partners or co-owners.

Bill might also be able to sell a revenue royalty for $1.0 million, giving the purchaser a royalty rate of 10% of the revenues of Bill’s Hut for 20 years.

The terms of the royalties we recommend, and in some cases have patented, are negotiable and include both investor protections, as well as an ability for royalty issuers to terminate the royalty prior to maturity.

Basic revenue royalties, including examples, can be studied at ˚

Two basics of royalty negotiation are the higher the royalty rate the shorter can be the royalty payment period and the greater the investor protections the lower can be the royalty rate.

As the revenue royalties we structure include an issuer’s right of redemption, we suggest 20-year royalty payment period to justify, based on issuer projected revenues, a reasonable royalty rate, resulting in a minimum Internal Rate of Return (IRR) sufficient to attract investor’s investment.

The terms of royalties can include; an issuer or third party assured return in an agreed period, a capping or limitation of return, the pledging of critical assets to assure contractual compliance and the commencement of a revenue royalty after the issuer’s repayment of a loan the investor either arranged or provided.

The limitation of the amount which investors will pay for royalties is based on the level of projected revenues and possible or assured minimum returns. Bill’s Hut is intended to be a simple example. Incidentally, I would like to believe that Bill becomes so successful in his first unit that he, using royalties, became a franchisor. The minimum size of a revenue royalty agreement should be multiple millions as the existence of a royalty is likely to make additional financing difficult and possibly require the redemption of the royalties, as a part of the use of proceeds of the future financing. Of course, the owner’s main benefit is ownership is not diluted.

When a publisher pays an author a percentage of first sales is the publisher issuing a security? When a property owner grants an exploration company the right to mine or drill on his property is he issuing a security? When a company pays an inventor for the right to use an invention is a security issued? When a performer’s agent negotiates a percentage of box office sales or a film’s revenue is a security being issued?

The definition of royalties, both from issuer and investor perspectives, differ by jurisdictions. Royalty payment assurance is not, we believe, insurance and royalties are not annuities. Revenue royalties are simply a contract, which is negotiated, between the owner of an asset, which can be money, and a party wishing to use that asset. The asset could be intellectual property, land use, equipment ownership or money.

Royalties can be used to enhance securities offerings or to replace the need for the securities. Investors will pay for the percentage of revenue entitlements, much as they pay for a fixed return in debt or partial company ownership in equity. It is all a matter of comparative analysis of the risks versus rewards and the ultimate success of the company getting the money.

It is easier to predict likely trends of revenues than it is per share earnings. In both cases company sustainability is necessary. However, royalties are paid irrespective of a company’s reported profitability. In the case of debt, other than earning interest, the best that can happen from the perspective of the lender, is being repaid.

Royalties are the better way of both investing in and financing of privately owned companies

Arthur Lipper, Chairman © Copyright 2019 British Far East Holdings Ltd.
British Far East holdings Ltd. All rights reserved. May 10, 2019