This week we contacted royalty licensing expert, the well-respected Arthur Lipper, asking the magic question. Why are you so strongly sold on royalty licensing as the most effective way to finance a tech-based early stage company?
I asked him five important questions, which he answered, and I’ve summarized below. Since I am a proponent of using equity as a tool and he is so much opposed, this week it is his turn to make the case. I have the weeks to follow to make mine. So here goes:
How would I find companies willing to license my intellectual property or to invest in a royalty stream from licenses? Would I hire a broker? Investment banker? Lawyer? Do it myself?
Arthur’s response: Identify the specific beneficiaries of your invention – and the companies already serving those beneficiaries. These are your candidates, because they are companies already absorbing much or all the marketing expense necessary to make sales of your invention. They will be more willing to pay a royalty fee if your product gets them to market earlier or is protected by patent to create a barrier to their competition.
How do I appraise my intellectual property to estimate royalty rates?
[Email readers, continue here…] Arthur: This is a matter between the owner of your IP (you) and the would-be user of your IP. The license to use your IP can be in the form of a one-time payment or structured as a continuing fee. If a continuing fee, the license could be based upon units of the product incorporating your IP. If so, be aware of the issue of how you can and do verify the licensee’s report of usage.
Does the average agreement call for advance payment of royalties? Do I understand the royalty replaces the need for equity investors?
Arthur: The usual royalty revenue sharing funding agreement is for an agreed period – and commences on the generation of revenues by the royalty issuer (company licensing the IP.) The royalty investor providing capital is a third party who makes a financial transaction with you, investing in you to receive a portion of the royalties from your IP. That party is only concerned with its royalty revenues and growth – and not profit from or valuation of its business. He’s bought the royalty, an intangible, entitling him to a percentage of your revenues. If you and your shareholders (the royalty issuer) really believe in the business and its intellectual property, then you should welcome financing arrangements such as shared royalties, which are non-equity dilutive and avoid reducing their percentage of ownership in your business. No owner of a business which became successful ever said: “I sure wish I had sold more of the company before it became successful.”
What are the advantages of using royalties instead of raising investor funds, other than no dilution of equity?
Arthur: The royalty investor is not concerned with your executive compensation or the quality of cars you may have leased for your executives to use. The licensee is not concerned with your awarding of options to buy stock on advantageous terms. On the opposite side, the investor in your royalty stream (call him the “owner of royalties”) is not concerned with the amount of money spent by the licensee company on staff education, the level of sales commissions paid, and the licensee company’s entertainment policies. Your royalty investor is only concerned with the licensing company’s revenue growth.
In you experience, what are the pitfalls of using royalties instead of equity financing and selling product?
Arthur: Only companies having healthy profit margins and the ability to maintain them should consider selling royalties. On the other hand, low profit margin businesses must sell equity and even borrow money where and when able. Companies with both growth potential and good margins should want to retain as much ownership as possible – and be willing to suffer a reduction in profits until the funds received from the sale of a royalty are used to increase revenues and profits.
So, there you have it. The argument for royalties from an expert and advocate. Starting next week, we’ll examine the process and advantages of raising money using various financial tools from notes to preferred stock to other more esoteric tools.