Should you sell to an equity firm or to a royalty corporation?

I recently met with a friend who owns a mid-sized business. She had received an offer to sell part of her business to a royalty corporation and was wondering if doing so would be a good idea.

In recent years, royalty vehicles have become more prevalent in Canada. Companies such as Diversified Royalty, Grenville Strategic Royalty and Alaris Royalty have been competing with traditional private equity firms to acquire financial interests in mid-market private companies.

My friend did not have a good understanding of how royalty structures work. I do, as at Yellow Point Equity Partners we recently sold a portion of one of our investee companies to a private royalty partnership.

So I began by describing what a transaction with a royalty corporation would look like.

A royalty transaction is in effect a sale-leaseback of intellectual property. In the transaction that we recently completed, the royalty company purchased the trademarks from the business. At the same time, the business licensed back the use of the trademarks in exchange for an ongoing royalty payment based on a percentage of revenue.

Although the above is typical, numerous alternative royalty structures are possible. In general, a royalty transaction enables the business to dispose of a portion of its existing earnings, while retaining some economic upside from expanding the business. The royalty company in turn gains trademarks that provide a stable revenue stream. This stream is not affected by the business’ profitability, and the royalty company is compensated by the owner if the business shrinks, for example by way of locations closing.

These royalty arrangements can be contrasted with transactions in which a business owner partners with a private equity firm. Over the years, Yellow Point has worked with many owners who wanted to diversify their wealth by taking a substantial amount of chips off the table while still operating their businesses and participating in future growth.

So, what liquidation strategy did I recommend to my friend?

The answer was (as with most things), “It depends.”

The most important consideration is, of course, cultural alignment. An entrepreneur will be working with either group, as a partner or a licensee, for the next five to 10 years. Therefore, I told my friend that finding a group that works well with her business’ culture and is aligned with its vision is critical.

Next, I advised her to consider the advantages of each arrangement.

Royalty companies pay premium valuations for businesses with stable cash flow. They often gravitate towards franchised or retail businesses, where revenue streams are generated by dozens or even hundreds of locations that, in aggregate, produce predictable revenue. Royalty companies typically are uninvolved in the strategic initiatives of the underlying business, as they hold securities that are more debt-like in nature and they get paid based on revenue.

Private equity firms, on the other hand, seek to establish partnerships with their management teams. The right private equity firm will own the same securities as the entrepreneur and is willing to hold the investment for an extended term; this aligns their interests in the ongoing profitability of the business and usually results in a higher level of engagement. To that end, and in contrast to the royalty structure, the private equity firm may forgo dividends and, indeed, invest additional funds when the business needs it.

Our experience suggests that, for most businesses, the private equity structure is preferable.

Since royalty companies are paid based on revenue, they are uninterested in profit-enhancing initiatives that may distract from sales-growth initiatives. This creates a potential misalignment of interests between the business owner and the royalty company. In contrast, private equity firms are co-owners of the business’ profits and as a result have aligned interests. They are therefore actively involved in strategic oversight and the key initiatives of the business. They add value where they can, with things like recruiting additional senior management team members, providing a sounding board for strategic decisions, completing acquisitions, and helping to prepare and implement succession plans.

As for my friend, she ended up passing on the royalty company offer. She wants to retire in the next five to 10 years. The royalty company offer provided cash, but it would have left her with the same succession issues, in a company that would have lower underlying stability given the royalty obligation. This didn’t give her confidence that her employees and customers would be taken care of, or that she could gradually disengage from the business. She is now considering selling to a competitor or private equity firm. 

Tyler Smyrski is a partner at Yellow Point Equity Partners. He is a past president of the Association for Corporate Growth’s B.C. chapter, and is a past winner of the Business in Vancouver Forty under 40 award.