A revenue royalty (royalty) contract reflects the terms of a transaction in which a company sells a negotiated percentage of its defined revenues, for an agreed period, to one or more investors. The terms of the royalty agreement may, with the approval of the parties, be subsequently modified. Royalty investors do not hold ownership interests in the company which sells the royalty, and they are therefore not directly concerned with its reported profitability. Royalty payments can be made at the time of the company’s receipt of revenues, or according to other payment terms as negotiated prior to the sale of the royalty. Unless the company has agreed to specific periodic payments, royalty payments are normally limited to a percentage of generated revenues as agreed.

There is a direct relationship between the royalty rate (percentage of revenues), and the payment period. The longer the company’s obligation for revenue sharing, the lower can be the royalty rate. Royalty payment periods can be set for whatever is agreed between the parties to the royalty agreement. In the case of intellectual property dependent companies, we suggest a 10-year maturity, rather than the 20 years we feel is reasonable for the broader range of companies.

Professional investors base their allocation decisions on the anticipated risk-related Internal Rate of Return (IRR). The greater the risk, based on the predicted achievement of projected revenues and therefore royalty payments, the higher the royalty rate. Our rex-basic.com website platform provides analytical approaches, some of which are patented, and fully discusses the structuring and use of royalties in the financing of companies.

As is the case with all contracts, corporate business performance and the prior negotiation of terms will determine the investment results of the transaction. There are two important aspects of contractual terms which need to be addressed: the remedies for non-achievement of minimum projected revenues, and the issuer’s Right of Redemption, which allows for termination of the royalty, based on royalty payments made prior to the maturity of the contract. We provide clients with advice regarding both areas, as well as the other necessary details of a royalty agreement.

We believe that royalty payments are U.S. federal income tax-deductible for issuers, and tax-free for investors up to the point when they have received payments from the royalty issuing company equal to the amount paid to the company for the royalty. In comparison, the amount of interest paid to lenders is federally tax deductible to companies repaying debt. Advice from attorneys and tax advisors is recommended.

We need the following data to develop the terms of a royalty transaction: the amount of financing sought; the minimum projected annual revenues, which can be a Compound Annual Growth Rate (CAGR) of revenues for years in which annual revenues are not provided; estimated pre-tax and Net-After-Tax (NAT) profit margins; and the Price/Earnings Ratio (P/E) of companies which are comparable to the royalty issuing company.

Of greatest significance is the fact that business founders and other early investors will not suffer any equity dilution from the sale of a royalty. This is important to the company’s owners if the company becomes successful, because their percentage of ownership is not reduced. Even if the company becomes only moderately successful, royalty investors will benefit if there have been revenues generated and the royalty terms are well negotiated.

 

Arthur Lipper, Chairman                          arthurlipper@gmail.com
British Far East Holdings Ltd.                 858 353 7100 (Pacific time)