What do Reported Earnings Reflect in Privately-Owned Companies?

In privately-owned companies, there is a broad range of appropriate and legal means of both benefitting the longer-range value of
the company and serving the current interests of those controlling the company. Controlling successful, privately-owned companies
can be a very pleasant experience for individual business managers and their families.

However, the expansion of most companies requires additional capital and that capital usually comes from either debt or from equity
investors. If the money can be borrowed without the personal guarantee of the controlling shareholders, (which would be unusual in
the case of a privately-owned company) there will be both frequent and inflexible interest payments and likely restrictions on the use
of funds. If the added capital comes from selling ownership interests in the company, be it in the form of common shares, convertible
preferred or debt, there will be continuing pressure from the investors for the declaration of ever-increasing per-share earnings. The
reported profits incur the payment of income taxes, and the greater the reported profits the higher the income taxes.

Therefore, the owners of successful businesses, with the assistance of their legal and accounting advisors, have developed a series
of corporate actions which may benefit the company at the expense of reducing declared current profitability. Such actions may
include executive compensation and benefit programs, employee benefit programs, the purchase of deductible and depreciable
assets, expansion programs with associated marketing expense, research, executive and staff training, equity buybacks and
shareholder dividends, and many other exercises. The form and location of incorporation and creation of subsidiaries in tax-
favorable venues is all part of tax planning. Therefore, income taxes on privately-owned companies can be managed, and the least
costly money the company has for expansion is the money not paid in taxes.

The immediate and inevitable conflict is this: investors want the declaration of growing per-share profits and the controlling
shareholders may well want unrestricted use of company funds, which may be of direct and continuing benefit to the controlling
shareholders. The conflict is manifest in the decisions made as to expenditures having direct influence on per-share calculation of profits. The larger shareholders who do not choose to sell their shares and have a long-term view have a different outlook from the smaller and
more recent investors, who only bought their interests with a view to selling them at a higher price, at the earliest appropriate time,
as justified by the highest and most rapidly rising per share profits.

If expansion capital had been raised by selling a royalty, the conflict would be ameliorated, if not eliminated, as the royalty investor is
primarily concerned with the company’s financial stability and sustainable growth of revenues, not reported profitability or valuation.

Given facts and revenue projections for a client company, if funding can be obtained, we can create a number of scenarios using
royalties which we believe that investors who accept the revenue projections and other terms of the royalty will find compelling.

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

Arthur Lipper, Chairman, British Far East Holdings Ltd.

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