Royalties
a new way of participating
in the growth of a company
A Process Description
introduction for the professional investor
by Michael North
based on the work of Arthur Lipper III
an introduction for the general reader
is available here
1. The Mind of the Professional Investor
The professional investor is a fiduciary, as other people’s money is being exposed to risk in search of reward. The professional investor seeks the highest return available, given a level of risk that is acceptable when considering the prospective return. He or she is paid to employ client capital and to outperform passive investments; merely the purchase of conservative government bonds or buying a stock index fund does not meet the needs of most investors, since inflation protection, increasing income and asset enhancement are usually required objectives.
When considering the opportunity of investing in a growing private company with the potential for significant increasing revenues, the professional investor’s goal is to find a way to benefit from the company’s growth and to outperform comparable markets, without being exposed to the same risks as the owners of the business.
2. Basic Options
With a private company, the professional investor might seek to benefit by arranging a loan. However, the benefit is limited to the interest rate charged, which is highly competitive and based on factors largely beyond the investor’s control. The risk is possible default. Lending requires credit analysis skills based on information provided by the company, which must be verified.
The other major option — buying stock in a company (if the owners are willing to share their equity) — makes the future value of the investment based on earnings and declared profits. Declared profit is not a neutral, transparent business metric; it is a matter of some discretion and interpretation by company management.
For example, controlling owners often believe it is in their best interest to use all legal means to report the least amount of profit, in order to pay less in taxes. On the other hand, if the owners of the company plan on selling shares to the public, they may employ accounting practices that optimize reported earnings. It is also possible that some companies will opt to pay dividends to their shareholders, but this decision will be made by the controlling shareholders and the Board of Directors — minority shareholders have limited effective say.
In all these cases, investors, as minority shareholders in a private company, must accept limits on the transparency of information provided by the company about its profits — yet this is exactly the information that the investor needs to accurately forecast risk and reasonably assess opportunity.
3. A Third Option
Revenue sharing, through a financial instrument known as a royalty, has the benefit of entitling royalty owners to a percentage of the royalty issuing company’s revenues, without regard to reported profits. Therefore, as the revenues of the royalty issuing company increase, so do the royalty payments. Royalties may include minimum payments, if contractually agreed, and their minimum performace may be assured by a third party. The revenue of many companies will increase as a result of inflation, while profits may or may not. Inflation will tend to favor royalty holders, but not the purchasers of company debt. In this sense, royalty investing is not only an inflation hedge, but in some cases, an inflation benefit.
Investor risk when purchasing royalties is that of the ongoing, continued ability of the royalty issuing company to meet its contractual obligation to pay the agreed royalty. The royalty investor’s principal risk is reduced with the receipt of each royalty payment, and there can be arrangements where assets of the royalty issuing company, and possibly others, reduce the risk and provide assurance to the royalty purchaser. If the royalty is required to be collected on a daily basis, as we recommend, this also progressively reduces the royalty owner’s risk.
When a royalty is purchased from an established company, royalty payments commence immediately and are not subject to the discretion of the controlling shareholders or management of the company, as in the case of dividends. Also, it is likely that the rate of return to the royalty holder will be higher than with a loan of the same amount to the company.
4. The Company’s View of Royalties
The primary advantage to the royalty issuing company is the availability of funding, which may not be available from banks or conventional funding sources, on terms that do not require equity dilution. Many companies seek growth capital, but are unwilling to sell equity to investors due to the continuing financial disclosures required. Such disclosures, even if cloaked in confidentiality with investors, are competition-sensitive with companies in high-growth industries, where information about suppliers, partners, customers, technology and profit margins are critical.
Once there are equity investors in a company, the directors and controlling shareholders are fiduciaries, as all corporate actions must be intended to benefit all of the shareholders. This may constrain management’s options; when considering necessary actions that may reduce profit in the short term but are necessary to the long-term growth of the company, for example in research-and-development, strategic marketing, and major client discount accommodations.
Royalties are treated, from an accounting standpoint, as a variable (and tax-deductible) ordinary expense to the royalty issuing company, since they are a percentage of topline revenues. Some royalty payment rates may change in stipulated periods, or in response to the achievement of total return benchmarks, and in such cases the accounting would be adjusted.
5. Revenue Royalties may have Many Optional Features
As royalties become more common in the financial landscape, business professionals — including lawyers, accountants, auditors, investment bankers, angel and venture financiers, private equity firms and underwriters — will evolve many creative ways they can be employed.
For example, royalty payments can have either an agreed minimum or maximum amount or both. The rates can change automatically over time, or may be based on the achievement of certain milestones of total investor return, or internal rate of return. Royalties can be secured by the assets of the company, by a third party, or not secured at all. They can be convertible into common shares of the royalty issuer under specified conditions. They can be made part of a standard loan, as an incentive to increase the lender’s return. They can be bought and sold; they might be registered as publicly tradable securities, through a new securities exchange optimized to deal with royalties. This opens up the possibility of writing options and futures contracts based solely on a publicly traded company’s gross revenues, which is not currently possible.
Royalties may also be purchased by a royalty income fund or limited partnership, which might be designed to reinvest the royalty payments or to disburse them. Such funds could be focused on specific investment objectives, geographies or industries, and would be managed to diversify and mitigate risk. Royalties can be redeemable by the company — that is, terminated early by the company before they expire, at an agreed price based on discounted cash flow or other factors. Royalty investors can also have the ability to redeem the royalty at the end of a stipulated period and sell their “seasoned” royalties at a profit to other investors seeking current income. Royalties can be used as an added incentive for a loan or line of credit. This is just a partial list of what can be done with royalties.
But in their simplest form, an investor pays an amount of money in advance to the royalty issuing company, in exchange for a percentage of a company’s revenues for an agreed period of time. That’s it.
6. The Anatomy of a Royalty Contract – a Professional Model
How much is fair to pay, for what percentage and for how long? These factors can be reasonably estimated, if the company can provide a conservative projection of the company’s sales over a period of time. There’s an online interactive model one may use which demonstrates this, at http://www.rex-basic.com
To complete the most basic model, it is necessary to enter only four items: 1. total investment provided to purchase the contract; 2. maturity or duration of the contract in years; 3. the royalty rate (or rates, if variable royalty rates are desired during different periods over the life of the contract), and 4. at least the first year’s actual projected revenues, with an estimated compound annual growth rate (CAGR) filling out the rest of the years for the life of the contract (or rates, if different growth rates are projected in future periods).
The model also allows the company to enter three other items, to aid both the prospective investor and the company’s managers in understanding the impact of assumed factors: 1. the price/earning ratio typical for this type of company; 2. the company’s estimated NAT (net-after-tax) income, expressed as a percentage of total revenues; and 3. the interest rate that might be received from a comparable investment in other companies similar to the company being analyzed, for benchmark purposes.
The model then calculates full information on the royalty investment’s total return in both tabular and graphic form. It is possible to pinpoint critical breakpoints from this data, including for example the point in time at which an investor receives royalty payments equal to his cost, or when he doubles or triples his investment; to identify when both the compound annual rate of return and the internal rate of return, and when each is projected to go positive; and to view an estimate of the increasing market capitalization of the company, if it receives the prospective investment and as a result performs on its revenue estimates over time.
The model makes it easy to change assumptions, rates, time periods and all other variables, to assist both the investor and the company issuer in achieving their objectives and arriving at an equitable agreement.
As a convenience, sample cases are presented which are intended to help those entering their own. There are just three steps needed to access this model:
1. Click rex-basic.com/sign_up
2. Enter a username; our sample is “professional”
3. Enter a password; our sample is “investor”
4. Some sample data has already been entered.
5. Here, you may fine-tune the parameters of the basic revenue royalties model. Click “Apply a CAGR” to enter the information you have provided. To see details of the results, including long-term Internal Rate of Return, click “View Analytics”
6. After viewing the Analystics spreadsheet, you may click “View chart,” to see the information in visual format. You may also click “Print” to print the spreadsheet.
7. Click “View Calculator” to return to the data entry screen in order to modify your basic assumptions and see the results.
There is currently no charge to use this model. Users may create and store their models and data, and all information is kept confidential. The owners of the model themselves cannot access the information.
This model was conceived and developed by Arthur Lipper, Chairman of British Far East Holdings Ltd., the royalty approach patent owner and filer of a current related patent pending. Other websites may be useful for serious royalty investors and issuers; they are detailed in a complete index to royalty modelling tools, and a library of private papers, is available at http://www.royalties.website.
7. Summary
From the company owner’s point of view, capital is provided for growth through royalty finance without surrendering any ownership or control, without incurring debt, and without having to report everything management does to shareholders.
The issuer’s potential downside: a decrease in profit margin, because royalties come “off the top.” If the issuer uses the funds received for the sale of the royalty wisely, then gross revenue will increase — for example, through efficiencies from increased marketing efforts, new technology, better economies of scale or competitiveness made possible by the funds received for the royalty.
One criterion used to understand the relationship between profit margin and royalty rate is to first assess how much the profit margin will be reduced by the royalty. For example, a company with a current profit margin of 25% that pays a royalty of 5% of its gross revenue will see its profit margin reduced by 20%. The company’s plan for use of proceeds should demonstrate how, over time, it will rebuild its profit margin back to previous levels.
The investor participates directly in a company’s growing revenues, without regard to the reported profitability or valuation of the company. In the case of a company generating current revenues the royalty payments commence immediately.
Royalties will probably not produce the same amount of gain for those investors smart or lucky enough to buy stock in one of the few highly successful early stage companies which are able to achieve their profit projections, and then are either acquired or merged for a high price while still privately owned, or issue a successful Initial Public Offering. However, royalty owners investing in multiple companies, perhaps through a royalty income fund for example, will almost certainly receive a much better overall result than through either equity or debt investments.
The approach described for using royalties in the financing of businesses is reflected in US Patent Number 7813999; http://j.mp/royaltypatent. Pacific Royalties is a licensee of this patent, and is advised by Arthur Lipper, an experienced investment professional. Michael North, a business development executive, is an advisor to Pacific Royalties, which he conceived and introduced to important members of the investment community.
Royalties define a new, more equitable and usually more profitable relationship between investors and business owners. They avoid the inevitable and irreconcilable conflicts of interest between investors and business managers, and the constant contest over valuation, that are present in most equity purchases.
Royalties are a win/win arrangement and are the better way of both investing in and financing of privately owned companies.
Proposed implementation in Honolulu, Hawaii:
http://pacificroyalties.com
Arthur Lipper, Chairman
www.REXRoyalties.com
with the participation of Michael North