Royalty finance unpacked

Learn why Royalty Finance is typically used by emerging or start-up companies.

Royalties are usage-based payments made by one party to another for the right to the ongoing use of an asset.  Assets typically used as the basis for royalties can be intellectual property assets such as music, books, films, consumer brands, franchise rights, pharmaceutical products or harder assets such as mineral and energy deposits.  Royalties are typically agreed upon as a percentage of the gross or net revenues derived from the use of the asset, or they can also be a fixed price per unit produced or sold.

Royalty finance is a form of finance typically used by emerging or start-up companies to finance the development of an asset or innovation, in situations where the company may not be able to obtain more traditional forms of debt or equity finance.

Royalty finance may be attractive to growing entrepreneurial companies that are unable to borrow from a bank because they are loss-making, may not have sufficient hard assets to provide as security, or may require personal guarantees from the owners of the business.  Issuing equity may also not be attractive for small companies because early stage venture capitalists can insist on taking a large share in the company in return for the investment, or require the founder’s commitment to meeting ambitious profit targets and require a “liquidity event” such as a sale of the business or IPO in order to recoup their investment.

Royalty finance usually takes the form of a royalty loan that requires repayment as a percentage of the revenues.  These royalty loans are more attractive than traditional loans as the default provisions of royalty loans are generally less onerous than bank debt, and the payments are variable not fixed, falling if a company loses a major customer or has a poor year and rising if the company’s revenues rise.  Royalty loans can be fully repaid once the royalty lender has received back a particular amount, usually a capped, pre-agreed multiple of the original amount lent. Depending on the revenue growth of the company this usually takes five to seven years.

Investors providing royalty finance may obtain very attractive “equity like” returns with lower risk and better security than an ordinary equity investment in an early stage business.  Some royalty loans also have equity warrants attached to them so that if the company performs extremely well and becomes the next Facebook, the royalty lender will participate, to some extent, in the upside.  For certain industries such as pharmaceuticals and resources, royalty interests may be a cleaner way to gain exposure to the success of the asset with lower exposure to the operational risks and costs of the developing the asset.  Royalties are sometimes referred to as “private taxes” given they are similar to GST and / or specialist resources sector taxes such as the mineral resource rent tax.

For investors looking to gain exposure to royalty income streams there are royalty companies and income trusts listed on various stock exchanges (e.g Canada – see chart below).  These entities provide royalty income derived from mineral projects, oil fields and even restaurant chains.
 

 


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