Royalties are a form of payment for product or business acquisitions. They allows a purchaser to take over a company, while still sharing risk with the entrepreneur business owner.
Royalties are figured from either gross or net sales. A gross sales royalty will be a significantly lower percentage than a net sales royalty. Gross sales percentages are taken before cost is figured in and net sales percentages are taken after costs are figured in.
Gross sales percentages are easier for the entrepreneur to track but net sales percentages may protect the longevity and stability of the business when royalties are a variable cost instead of a fixed cost.
A royalty is like winning the lottery and taking annual payments. You know you have this money coming in, as long as the new company continues to produce sales. You’re free to move on and either take an extended vacation or to get going with another new business.
Many businesses do a royalty model in reverse. It’s called factoring and is considered to be very expensive financing. Both individuals and banks may factor receivables for businesses.
When you strike a deal for a royalty, you are essentially factoring sales not made for the new purchaser of the company.
Investors will sometime offer royalties to encourage an entrepreneur to exit when they are unable to take the business to the next level. Some will take it, others will take it personally and think they are getting a bad deal.
I can tell you that I wish I was offered a Royalty deal on previous companies that I’ve started. I’d have a healthy income from those companies and probably would not have to work again!
Royalties offer another significant advantage to entrepreneurs. You can literally structure a contract to require rights of the company or product be returned should the purchaser fail to make X amount of timely royalty payments over a period of time. You still maintain ownership rights if the purchaser doesn’t do what they say they’re going to do.
When you make a royalty deal, make sure you have competent legal counsel representing you that is familiar with this type of transaction. You’ll be glad you did.