Royalties: From Listerine To Texan Oil Wells
Chances are your teenage band didn’t take off, but you can still profit from other people’s musical talent thanks to royalties. The same is true of many other sectors including oil and gas, books, photography, and patents. Put simply, royalties are payments made by a licensee to a licensor to be able to continue using a certain asset.
One of the neat things about royalties compared to other investment vehicles is that they offer consistent passive income. Once a particular asset is produced, for example a song, the legal owner/s typically receive remuneration every time it is used. That’s what makes it attractive to big players like the Canada Pension Plan Investment Board which allocated US$325 million for partial royalties in cancer drug Venetoclax1.
Unlike some other alternative investments like private equity or venture capital, retail investors also have easy access to most types of royalties. And entry is getting even easier thanks to innovative platforms like Royalty Exchange and SongVest which enable royalty owners to sell their future payments to investors as alternative assets. Let’s take a look at the pros and cons of this popular alt and some popular royalty opportunities open to retail investors.
How Royalties Work: Listerine
Let’s take a quick look at a famous royalty example - Listerine mouthwash.
Every time you swish, swirl and spit your morning mouthwash, someone somewhere is making money. This unusual royalty dates back to 1881 when the product was first invented by Dr. JJ Lawrence who licensed the secret formula to J.W. Lambert and Lambert Pharmaceutical Co. In return Lawrence secured a royalty contract based on ounces sold to be paid out as long as Listerine was sold anywhere in the world.
As you can see from the graph below, Listerine royalty income seems to be a nice and steady earner thanks to the product’s critical role in the morning routine of millions of Americans.
Royalties Vs. Equity
Royalties and equity might sound similar, but the biggest difference is the ownership. Investors who own equity in a company either earn through capital gain or dividends. This income is proportionate to their stake. Equity income is affected by market factors.
Royalty payments, on the other hand, are made to the legal owner of a particular work or asset. Royalty incomes are often affected to a lesser degree by wider market forces. The main types of royalties include patents, copyrights, natural resources like oil and gas, and property or land.
Royalties Pros & Cons
Before jumping into any investment opportunity, you should make sure you understand the possible risks and rewards. Let’s run through some of the pros and cons of royalties for retail investors. Bear in mind that each particular type of royalty will come with its own specific set of pros and cons, so it’s worth doing your homework carefully before parting with any capital.
Pros
Low correlation: Music royalties, for example, tend to be unaffected by public market dynamics. This can make them an interesting option for portfolio diversification.
Yield: Some royalties can generate better revenues than bonds or dividend-paying stocks. For example, Royalty Exchange reported a six-month annualized asset ROI of 10%.2
Consistency: Investors can be almost certain of receiving a payout with royalties. Royalties on books, music, and many patented products like pharmaceutical drugs are paid out depending on how many units are sold. This makes it a good option for retail investors looking for consistent passive income.
Cons
Illiquidity: Finding a buyer when you want to exit can be challenging, especially for niche music or book royalties.
Loss of principal: Depending on the royalty model, there’s a risk that the value of your royalties will decline over the course of the investment. This is common with entertainment royalties for artists who were once very popular.
Volatility: Big price swings can be an issue and it can be very hard to forecast future earnings. This is especially true for oil and gas royalties. Those who invest in music royalties can get lucky if a particular song or artist starts trending or appears in a big movie, but it’s almost impossible to predict if or when this might happen.
Little control: Taking oil royalty trust as an example, investors are not directly investing in the company. This means they have very little influence over operating decisions which can affect the company’s performance.
Music Royalties
This is probably the most well-known type of royalty and one of the easiest to understand. Performance royalties are paid whenever a piece of copyrighted music is used anywhere in the world. Thanks largely to the rapidly-growing streaming trend amongst Millennials and Gen Z, music revenues are predicted to increase significantly over the next decade. Goldman Sachs expects total music revenues to double in size to $131 billion by 2030.3
Music royalties can be lucrative, but it can be a tricky market to succeed in without expert knowledge of the industry and significant capital to invest in the big names. For example, Round Hill Music Royalty Fund owns Chris Kenner’s “Land of a Thousand Dances”, which appears in the movie “Forrest Gump”. According to the CEO of Round Hill, the song generates between $300,000-$400,000 a year.
Music royalties aren’t all about the money, though. There’s also the added value of supporting an artist or music project to grow and develop. That’s why it’s a good idea to only invest in artists you truly believe in. Bear in mind that music royalties do have an expiry date which is usually the lifetime of the last surviving artist plus 70 years.
Key Players
Several platforms have sprung up to cater to retail investors who want to hit the ground running with music royalties. Songvest and ANote Music are two popular options which allow investors to buy and sell royalties and receive dividend-like payouts. ANote only works with music catalogues with a minimum of 3 years of stable royalty history, whereas Songvest has the option to help crowdfund new and upcoming albums in return for royalties.
Billed as the world’s biggest royalty marketplace, Royalty Exchange offers the possibility to further diversify your portfolio by turning music into NFTs. While not strictly a royalty model, this can offer creators the possibility to enter the booming NFT scene and tap into a big pool of new potential buyers and fans.
Oil & Natural Gas Royalties
You might not have the capital or desire to buy an oil well, but oil royalties give investors an easy way to profit from these types of operations. It works similar to having part-ownership of an oil or natural gas well. The oil or gas company can issue units of a royalty trust to raise capital. Earned profits are distributed to shareholders after deduction of the operational costs.
Oil and gas royalties have some unique advantages including exemption from corporate tax and the option to lower your cost basis via asset depreciation, delay your taxes, and benefit from tax credits for US taxpayers. Often, royalty trusts are also required to distribute all cash flow, which can mean higher yields for investors. Yields for the ten largest oil and gas royalty trusts range between 8.4% to 28.5%.4
Yields depend on how much the wells are producing as well as fluctuations in oil and gas prices which can cause significant volatility. The most important thing to keep in mind for oil and gas royalties is that yields typically fall over time as the well becomes less economically viable. This means there is no iron-clad guarantee that you’ll earn back the principal. Oil and gas royalty trusts thus operate in a similar way to bonds with a fixed investment term.
Key Players
There are around 20 royalty trusts currently traded on US exchanges. A couple of interesting options are Sabine Royalty Trust (SBR) and PermRock Royalty Trust (PRT).
SBR was formed in 1982 and has royalty interests in proved oil and gas properties in Florida, Louisiana, Mississippi, New Mexico, Oklahoma and Texas. According to Investor Place, rising energy prices indicate SBR is on track for a 6.5% annualized distribution yield.5
PRT specialises in the acquisition, development and operation of oil and natural gas properties in the Permian Basin which is the most prolific oil-producing area in the U.S. PRT’s total annualized distribution yield is likely to exceed 6.2% since distributions at the beginning of the year were depressed by the pandemic.6
Venture Financing
Royalties can also be used as an alternative to equity for venture financing in a model known as royalty-based or revenue-based financing (RBF). This can be a useful investment vehicle that allows investors to profit without getting involved in the company and the company to raise funding without having to give up equity.
Another benefit for investors is that they can receive regular income without having to wait for an exit event like an IPO or sale of the company. Investors typically get a monthly payout linked to company revenue. Royalty financing may also have a lower risk of default thanks to flexible payment terms, and if the company does default, investors can expect to get paid back ahead of those with a stake in the business.
Key Players
High-profile investment firms that specialise in the royalty-based model include:
Cypress Growth Capital which is the largest royalty-based growth capital investor in the US with over $100 million AUM. Cypress specialises in royalty-based growth capital for tech companies with annual revenue of $3-30 million and at least two years of operating history.
Bigfoot Capital offers flexible lending structures including RBF and hybrid options. They specialise in growth debt facilities up to $5M for SaaS companies with $1.5M-$15M in revenue.
Royalty-based financing tends to be the preserve of institutional investors and accredited investors due to the large amounts of both capital and risk involved. However, there are ways for smaller retail investors to get involved such as royalty-based crowdfunding platforms like LocalStake.
These tend to have fairly low minimum investment thresholds and work on a revenue-sharing basis where the company repays a certain set percentage of revenue. For example, a company may offer investors a 1.5x multiple in return for the funding they need. The company would then pay back its investors according to revenue until the full debt has been paid off. The investment term thus depends on the success of the business and how fast they can grow their revenue.
Final Thoughts
Royalties come in all shapes and sizes, which means it’s easy to find an opportunity that suits your financial goals and risk appetite. If you’re a big music or entertainment fan, supporting your favorite artists as well as the possibility for financial gain can be particularly attractive. It’s also an interesting option for investors looking to get involved in VC or angel investing without having to commit time and effort to the company itself.
Disclosure: All opinions expressed herein constitute the author’s judgement as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions and the experience or expertise of the author are based on current expectations, estimates, opinions and/or beliefs. Such statements are not facts and involve known and unknown risks, uncertainties and other factors. Past events and trends do not predict or guarantee or indicate future events or results.
Goldman Sachs, “Streaming Turns Up the Beat for the Music Industry”
Investor Place, “3 High-Yield Royalty Trusts to Watch”
Investor Place, “3 High-Yield Royalty Trusts to Watch”