 My name is Michael North and I'm hosting an extraordinary person today, Arthur Lipper. He's joining us by Skype from San Diego and we're going to be talking about a new method of providing financing for growing young companies that Arthur calls revenue royalties. Good day, Arthur. How's San Diego today? Beautiful as always, Michael. Delighted to see you. Delighted to see you too, Arthur. And Arthur and I have been friends and associates for a number of years and I haven't had him on this show yet and I thought, why not? I'll get this gentleman here because while Arthur, there's a description of you in the show notes here. Everybody can watch it but nobody reads anymore. So could you give us the nickel tour of Arthur Lipper, where you came from and what you've done and why? Well, we have a short show. How it could take all night? I'm essentially two-part as far as royalties go. Number one, I'm a Wall Street animal having formed and managed two relatively large member firms of the New York Stock Exchange and all the exchanges and the commodity exchanges. And also I was the owner and editor-in-chief of Venture Magazine with 450,000 paid subscribers. So the experience that I've had with hundreds of companies in terms of either investing or advising them has been augmented by the thousands of companies that were covered in Venture Magazine over the 10 years. So I think that's really what is necessary to explain perhaps why I created royalties. And I did that because I see an irreconcilable and inevitable conflict of interest between investors in private companies and those who found private companies and on and manage them. And give us the 10-cent tour of royalties. We understand you've been around for a little while. I guess you were involved in the financial community since the early to mid-60s. So you've seen a lot come and go and somehow at this stage in your career you've decided that this royalties thing is significant for business people to know about. Why is this so important? Just give us the quick top-level outline. Okay, number one, I've been involved in Wall Street since the early 1950s. Number two, royalties, a percentage of revenues of the royalty issuing company are the most direct and fairest way of rewarding both investors and others who make a contribution to the success of the company. Profits, which are the measure that investors in equity use, are a discretionary item. They're discretionary to the degree that companies have perfectly legal means of controlling the amount of profit reported. And number two, the profits of a company are to a much greater degree outside the control of the management than our revenues. So Arthur, you're talking about top-line revenues and you use this word royalties. You use this word royalties, which is we commonly associate royalties with the movies or with books or maybe with mining and oil and gas and so on. But what you're talking about is not that. It's not Stephen King in his latest novel or the latest blockbuster movie on the screens. This is a different kind of royalties. What's the difference between those types of royalties and your investor style, say revenue royalties? That's absolutely correct, Michael. Royalties have been around for hundreds of years and have been used in a wide range of industries. The royalties that you're talking about as issued by publishers, theatrical stages, oil and gas, mining are very different. Mining has made the greatest use of royalties, but franchising essentially is a royalty business as well, where the franchisor receives a premium off the top of the total revenues of the franchisee as a right to use their name and business mechanism. Now, I found that in investing in private companies, as early stage companies are, that I was in the unfortunate position of having to negotiate ownership of the company with the founder. You mean the valuation of the company? No, not the valuation, the percentage of ownership, which is different than valuation. My point was that I was embarrassed and founded unconstructive, determined that we had a mutual interest in increasing revenues. The business owner in private companies does not always want to report the highest possible profits and pay the highest possible taxes. Many businesses are able to grow based upon capital that they did not pay in taxes. That is a conflict between the interest of the business founder and manager and that of the business investor. What's the chief advantage of your plan with revenue royalties for the owner of the company, the issuer of the royalties? Let's focus just on that for a moment. The principal benefit is that there is no transfer of ownership of the company. All the royalty purchaser is buying is an agreed percentage of the defined revenues of the company. So you're not selling stock in the company. A young company is not selling 20% of its equity to a venture capitalist, right? Well, in point of fact, it's much more likely to be selling 60% of its equity to the venture capitalist if any serious amount of money is involved. The experience of the entrepreneur founding a company financed by the venture capital industry is that after the financings are done, he will end up with less than 20% of the equity. And so that's not in his or her long-term interest. They're not retaining control over the company and they're not retaining ownership so that if the company does succeed and it's ultimately worth something on the market, then their total return may be reduced to from 100% to 20% over a series of stages. Is that correct? That is correct. But even more concerning is that they are highly likely to have their job function either shifted or eliminated by the controlling investors, which are the venture capitalists. And in most cases, the venture capital, the capitalists believe that it is a different skill set required to start a business than to run a business. And sometimes they're right about that. They certainly are right about that. And one can value both skill sets, but one can hire business managers. It's difficult to hire business founders. So is it safe to say that for the issuer of a company accepting a royalty investment, they in general maintain more control over their company, its destiny and the rewards that they reap for the hard work that they put in? They maintain total control as far as the royalty investor is concerned. And of course, one point that is mandatory that people understand is that royalty payments by the company. I think what Arthur is saying is royalty payments are tax deductible to the company that makes them to the investors who receive them. So they take in a royalty investment and then they pay out the royalties that are due as a percentage of their gross revenues. Exactly. And in the hands of the investor, the royalties are a return of capital until the investor has recaptured their investment. This is the initial investor. And thereafter, the royalty payments are ordinary income. Let's get concrete about this. Let's give an example. A company is seeking, let's say, five million dollars in capital in order to expand their business. And they're interested in royalties. And does the company need to have a track record of revenues? Do they need to be an established company? Is that the ideal situation? Well, it's the ideal situation perhaps for an investor who is conservative. That company are likely to be based upon projections. The projections will be made by the company. And there are means to assure that the projections are conservatively projected. The company may agree to pay, for example, let's say, 7% of their gross, their top line revenues to investors for a period of time, let's say, for five or six years in order to allow the investors to recover their capital. We're going to take a break for a moment and we'll be right back. This is Think Tech Hawaii, raising public awareness. Hi, I'm Pete McGinnis-Mark. And every Monday at one o'clock, I present Think Tech Hawaii's research in Manoa, where we bring together researchers from across the campus to describe a whole series of scientifically interesting topics of interest both to Hawaii and around the world. So hopefully you can join me one o'clock Monday afternoon for Think Tech Hawaii's research in Manoa. We're back with Arthur Lip. We're talking about revenue royalties. And Arthur, I wonder if you would help to walk us through an example, because you've put together some analytical tools that make all this very direct and concrete. We're able to enter the key information about a company and its anticipated revenue growth and the rates of royalties and see what kind of a royalty contract might be viable in the interest of the investors and in the interest of the company. So your model is available at RexRoyalties.com. And we constructed a sample scenario here where a company receives $5 million in capital. And for the first six years, the company agrees to pay 7.5% of its gross revenues to investors. And then for the next several years until year 10, that royalty rate declines to 5.75%. And then it declines again for the balance of a 20-year term to 4.5%. So those are a couple of the key components to entering a royalty scenario. And then the next ones, the key ones, are the anticipated gross revenues of the company, which the company should be able to provide from its own sources for the first five years. Sort of a bottoms-up analysis based on where the revenues have come from, where they are today, and where they are anticipated to grow given the application of this $5 million in capital. And then your model allows us to enter an anticipated compound annual growth rate. You can see it on the screen here as CAGR. That after those first five or six years where the company can make its own projections, the company says, OK, then starting in year 7, I think we can keep those revenues growing at 16%. In year 12, we'll be pretty big by then. So we can keep it growing, but maybe just at 12%. And then for the balance of the 20-year term at 10%. So I think I've summarized all of the really key, the core values that need to be entered to understand a revenue royalties scenario. There's some others that are sort of benchmark and modeling tools, but am I correct? It can be that simple in creating a revenue royalties model. Yes, except that in an early stage company, it's likely to be pre-revenue. And the model that is shown assumes that there is a basis, a base revenue. Right. So this is not a pure early stage company. This is a company that has been in business for some time and has a track record of revenues. The issuer to be conservative because he gets a benefit if he exceeds the projected revenues and has a penalty if he underperforms from what he is projected. So can we look at that in the control room? Can we look at screen 5 here? I was just outlining what that means. This is the basic scenario. And the assumption is that we're dealing with a company that has existing revenues. Now let's go forward to screen number 6. And this shows a table of the anticipated results. And Arthur, in the column that's labeled IRR, our internal rate of return, if we go down to year 20, this model is generating an anticipated internal rate of return of 18.7%. Is that a desirable? Is that a feasible result for a royalty's investor? It depends upon the industry in which the company is active, the maturity of the company. 18% would be okay, but not exceptional. In an early stage company, you probably, as an investor, would want more than a 20% internal rate of return. So this is sort of a middle-of-the-road type return. It's not very high, it's not very low. What's the lowest rate of return that a royalty's investor might look to accept? Well, the answer is it depends upon the stage of the market. And probably it should be something like 150% of the prime rate of interest charged by a commercial bank for a term loan. Right, which would be right now probably eight or eight and a half percent. So are we saying right around 11 or 12% would be the low water mark for a royalty, but we're trying to get to 20% or higher if we can? The royalty rate is established to reach an internal rate of return based upon the level of revenue. Right, now let's go to the screen number seven, if we can. Arthur, we're showing this screen now that is a graphic representative of basically the rate of return to be anticipated over 20 years. And you can see how it slopes up, it declines a little bit, it slopes up again, it declines a little. And those are artifacts of the fact that the growth rate changes and the royalty rate changes at different points during the 20-year term. So although the general trend is always upwards, there are some advances and declines that are part of the natural progression of this model. And the graphic allows us to see that clearly. Yes, and to the extent that revenues are positively impacted by inflation, royalties have an advantage of inflation, whereas profits are negatively impacted by inflation. So let's go back to the live shot now. Are you saying that royalties are a kind of a hedge against inflation? I don't want to call them a hedge but they are positive revenues for most companies where they have price elasticity and can raise the price with the inflation, the royalty benefits, because it's focused solely on the revenue and has no interest in the profit level. Right, and doubly so no interest in the profit level because you're not trying to create a future valuation based on profits that the market judges you buy like your PE ratio, for example. That's a measure of profitability and for a royalty's investor that's of secondary interest. Is that correct? Well, the pricing's ratio is not really of any interest to the royalty investor, nor is the market valuation of the company of any interest to the royalty investor because they're never going to be an owner of the business. They are only an owner of an agreed percentage of defined revenues. And I want to take a moment to emphasize the defined revenues. They could, for instance, exclude international sales. Another interest that investors have, obviously, is that the company survives and thrives in order to generate revenues and hopefully an increasing pattern of revenues. Otherwise, there's no royalties to pay, correct? No. There are always royalties to pay as long as there are revenues, but the amount of revenues will be disappointing to the investor if the revenues do not increase. Right. So we need to be satisfied in the basic soundness of the enterprise before we invest at all. We're not just purely interested in the top-line revenues. We have to make sure there's something under those top-line revenues to sustain them over time. Revenue growth will come from both the customer satisfaction with the product or service, but also the company taking market share. We've come to the close of Royalties 101 with Arthur Lipper joining us by Skype from San Diego today. I want to thank you, Arthur, very much for joining us. And we may be able to pick this up again at another time to get into a little bit more detail. So from Honolulu, we bid you aloha and have a great day.