Cite this work: S. Shafqat (2021). Are Royalty Deals Bad or Good. Risk Concern. Accessible at: link.
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A question that entrepreneurs, small businesses, and even some larger firms often face when pitching to external angel investors, venture capital firms, private equity firms, etc., is whether royalty deals are bad, or whether they just have a bad reputation.
This report analyzes royalty deals in-depth to explain their nature, their impact on the business, the value of the company, and the potential benefits of such deals, so decision-makers can make an informed decision.
Royalty payments are a fixed outlay as per the percentage of sales, and sometimes net profits, that the business must pay on some or all of their products sold. A royalty of 10% of sales on all products would mean that if a firm sells $1000 worth of goods, they would have to pay $100 to the party they have a royalty deal with; a royalty on one product would be limited to that product only, and a royalty on net profits would, of course, be less burdensome than the same applied on all sales, as the firm would have to pay the external investor only after all other expenses have been paid.
How should royalty payments be classified?
As per their very nature, such payments can be considered a sales-volume-dependent debt, as they fluctuate with the sales volume. These payments are a fixed outlay that the firm is contractually obliged to pay; they should be considered as debt on the firm, but a debt that fluctuates as per the firm's performance; it is a more confining form of a liability than a regular form of debt.
The interest payments on a loan, for example, have an inverse risk and outlay relationship with regular sales, i.e., all else equal, if sales increase, the firm should have a higher operating profit, and thus the fixed interest payments would reduce in size, in comparison to overall net profits, as sales increase. This inverse risk and outlay relationship do not apply to royalty payments, and that makes them a more confining form of debt (worse than regular debt, basically).
Does a royalty contract with an investor help the business by protecting the equity stake of shareholders?
Investors may argue that through such a deal, the founders or shareholders are protected from the reduction in ownership stake, as through such agreements, the investor(s) usually demand only a small equity stake, typically demanded as goodwill.
However, it is important to understand that when an investor(s) invests in a corporation by purchasing equity, the firm isn't obliged to pay them a dividend; but a contractual payment cannot be avoided.
Furthermore, when an investor purchases equity from a start-up, etcetera, the money they pay either goes to the shareholders selling the equity as personal capital gain, or goes back into the business for growth; essentially, the equity is exchanged for a monetary value that the investor pays.
However, when a business does a venture debt deal or a royalty deal, and must give up a portion of equity as well, they must pay the interest on fixed debt, or contractual payments based on sales, which is, entirely, the cost of capital they receive from the VCs or angels. But, the equity they give up, unlike a purchase of equity for an investment, is not exchanged for a monetary value, i.e., it is given for free. Instead, they pay the cost of capital as interest payments or contractual payments based on sales, and they must also give up equity for free, which may be very valuable, or may become very valuable in the future.
For example, if a business with a revenue of $400,000 p.a. is offered $300,000, with a deal based on royalties: $2 per every unit sold, till 2X ($600,000) is returned on the investment and 6% equity, additionally. The 2X required rate of return, if paid, say, in 3 years, would equate to an equivalent yearly interest rate of 26% (((600/300)^(1/3))-1=.26), a rate 13X higher than a 2% risk-free rate on government bonds, and a risk premium of 24% (for a comparison, interest on junk bonds has historically hovered around 9%).
Such a high rate should be considered more than enough as a cost of capital; however, the additional 6% equity demanded, for a business valued, at, say, $2.5 million, would be an additional cost of $150,000 for the shareholders, amount they lose by giving up 6% equity. Thus, the present value of the sum received by the investor, shouldn't be considered $300,000 (what they offer), but we need to subtract the present value of the equity that must be given to the investor as part of the deal, making the initial economic inflow = $150,000 ($300,000 (sum received from investor - $150,000 (value of 6% equity).
Therefore, the money received from a VC deal involving royalties should subtract the present value of the equity that must be given to the investor(s), to evaluate the net value received from the investor(s) and for assessing the cost of capital that must be paid on that amount by the firm.
It should be noted here that if the cost of capital demanded is considerably low (i.e., interest rate demanded or the contractual payments demanded), compared to what the market would demand, then giving up an equity stake that equally offsets the lower cost of capital, and compensates the investor, overall, at a reasonable market rate of interest. Such a debt shouldn't be considered significantly worse than a straight-up equity sale.
For example, in the above-stated example, if the investor demanded a royalty payment of 10 cents per unit sold until 1.5X original capital was paid, plus 1% equity. If we assume that it would take the investor 15 years to be paid back, the rate of return on such investment would be approximately 3% (((450/275)^(1/15))-1=.033); if the investor can generate similar returns by investing in risk-free government bonds, it would be nonsensical for the investor to instead invest in a risky start-up, etc.
Giving up an equity stake that would commensurate the return with the risk would be reasonable in such a case. Giving up a 10% stake, valued at $250,000 (as per the above-stated example) would be reasonable, as it would equate to a rate of return of 15.7 (((450/50)^(1/15))-1=.15.7), without considering the time value of money, and, assuming a uniform yearly distribution of $30,000 by the firm to the investor as royalty payments, a rate of return of about 11% (((241.4/50)^(1/15))-1=.11), considering the time value of money with a 9% discount rate.
How does a royalty deal impact the valuation of the company?
When a business must pay an obligatory percent of sales, its bottom line, returns on equity, and retained earnings are impacted.
Below, an income statement of a hypothetical business with $5 royalty per unit sold is depicted, with and without such a compulsory payment (per 35,000 units sold):
As we can see, such payments directly impact the operating income (earnings before interest and taxes). However, a further critical point that we must understand is that as the net income is reduced, the return on equity (ROE) (net income/shareholders equity) is reduced as well. The reduction of net income and ROE negatively impact a company's valuation.
The equity held would be less valuable as the ROE declines, and the value of the company, as calculated through discounted cashflow, dividend discount model, multiple on EBIT, or multiple on earnings method, would decline.
In the above-stated example, the ROE is reduced from 17.5% to 11.4%, and net income is reduced by 35%. This should have a proportion impact on the valuation of the company, and in the next funding round, due to such compulsory payments, the value of the company, other factors held constant, should reduce.
This, of course, is antithetical to the objectives of increasing the valuation of the company in later funding rounds.
Are there any benefits of a royalty deal for the entrepreneur, start-up, and businesses?
While there are multiple adverse impacts of such payments, there are, nonetheless, benefits as well, and these should be examined seriously. The benefits, however, may be idiosyncratic, i.e., deal-specific, and must be understood holistically, taking into account any synergistic value that the partnership with the investor(s) may add.
For example, in the issue expounded in the last section (business valuation), It must be noted that if the company can increase the price of its products, enough to offset the addition of royalty payments, then its net income wouldn't be impacted. It is important to understand that if an external investor increases the brand recognition of a company, to the degree that it can increase the prices of its products enough to offset the obligatory payment per-product-sold, that must be paid to the investor, then no negative impact should occur on the valuation of the business.
Similarly, if an investor(s) can reduce the cost of the company's goods or services, or increase sales exponentially to the degree that net profits increase, then it would be beneficial to do such a deal. This may be achieved through the better industry contacts/alliances of the investor.
Another critical factor that must be considered is the customer acquisition cost. If an external investor can reduce the company's customer acquisition cost, more than the royalty payment that must be paid to her, then such a deal would be advantageous and have a cost-reducing effect.
Such a benefit can be achieved if the external investor has an alliance with other businesses that share customer data, distribution channels related data, and strategies, in essence working as a quasi-syndicate to mutually enhance value.
Other cost reduction synergies may also be achieved; for example, the investor may have an inhouse marketing or SEO related capabilities that the firm may be able to utilize; by doing so, the company may significantly reduce their marketing cost, and gain higher efficiency and effectiveness, per dollar spent. Such a benefit, per unit sold, may be higher than the royalty payment and thus beneficial.
Lastly, a claim that is often repeated by investors that propose such deals: "if you do this deal, our interests would be aligned, we will work hard to sell your products/services so we can make money."
There is some merit to this statement. An investor with such payments may make significantly more than, say, a straight equity investor. Such incentives would, of course, motivate the investor to try to sell more of the firm's products/services. If they sell the products/services quickly, the yearly rate of return that they would receive would be higher compared to a slower pace of sales (as explained in the third part of this report). They would make their contractual 1.5X, 2X, etc., return faster, with an extraordinary rate of return. The devaluation of their money will also be limited if the return on their investment is realized quickly.
Thus, all in all, these factors would significantly motivate the investor(s) to sell the firm's offering, more than straight equity investors. Such a motivation harbored by a well-connected syndicate, at a reasonable rate of royalties, can be very advantageous for the firm, and can substantially increase sale volumes; higher volume trading can also reduce manufacturing costs.
In conclusion, it is important to weigh all these factors seriously, evaluate the synergistic advantages that would be achieved through such a deal and compare these to the costs. Success in business should always be based on logical, tactical moves, based on strict principles of validity, divorced of all emotion. When an investor proposes such a deal, some businesses may think that they are being greedy. This may be the case; however, a serious inquiry based on a cost-benefit analysis must be conducted to evaluate all such deals.
If you are pitching to VCs or angels, and you must decide there and then, whether you are making a deal or not, you must conduct all these analyses in advance, so you know the lowest or highest that you can go.