How To Establish Deferred Royalty-Based Compensation for Undercapitalized Businesses

Many first-time small business owners have a technical background but lack the business acumen to make the most of a new venture. Most of these same small businesses are undercapitalized, so they cannot hire the right resources to fill critical roles as they prepare to go to market with their product or service. Many of these founders also want to retain complete control, remain the king of their business , and do not want to dilute their ownership during the early stages by bringing on partners or investors too early. So, what does a startup entrepreneur need to do? One option is to create a framework for a deferred royalty-based compensation strategy based on the business’s potential future earnings as a way to compensate these early support resources, whether an individual or another business entity, for their contribution to the business’s future success.



A royalty is a payment arrangement where a resource receives a share of the revenue generated by a business or intellectual property. With deferred royalty-based compensation, you create a payment arrangement where the resource will be entitled to a share of future revenues in exchange for work performed today or for other considerations.



Small business founders invest their time and money when starting a new business in what is often called risk capital. Since many businesses never achieve break-even, the risk-taking must come with a reward that compensates for their risk incurred . The same is true when it comes to resources that assume the risk of ever getting compensated for their efforts based on a deferred royalty-based compensation strategy when working for a pre-revenue business .



Consider how most personal injury lawyers are compensated. Since, more often than not, the injured party does not have the means to pay the retainer required to hire a lawyer to handle their case, most personal injury lawyers agree to take a percentage of any settlement that the firm can secure for the injured party as payment. The firm is not paid if they fail to win a settlement or a case brought before a jury. However, if the firm wins a settlement or a jury trial, the fees they receive exceed what it would have cost the injured party had they agreed to pay the attorney on an hourly basis. This is because the law firm assumed the risk of not getting paid had they not reached a successful outcome. Based on the risk assumed by the law firm, their compensation includes a hefty risk premium. It’s a similar risk premium that your business should be willing to share with a pre-revenue resource when contracted under a deferred royalty-based compensation strategy.



There are several factors to consider when attempting to establish a deferred royalty-based compensation strategy for resources willing to work today in exchange for potential future risk-adjusted compensation. Here’s a suggested approach to defining their compensation structure:




Determine the Royalty Percentage



Define the Royalty Duration or Cap



Define a Gradual Decline of Royalties Over Time



Define Contribution Metrics



Create the Legal Contract




Determine the Royalty Percentage



Begin by agreeing on a fair percentage of future revenues to be allocated as royalty payments to the resource for their pre-revenue contributions. This percentage should reflect their value to the business and factor in the risk that they may never receive full payment for their efforts.



Determining the royalty percentage is a subjective process, but here are some steps you can take to help determine a fair and reasonable percentage:




Assess the Value of the Contribution : Evaluate the potential impact of the resource’s contribution to your business. Consider the expertise, experience, network, and other resources they bring to the table. A higher value of contribution may warrant a higher royalty percentage.





Financial Projections : Create financial projections for your business, factoring in the resource’s contribution and potential revenue growth it may generate. Consider how the resource’s efforts might translate into increased sales, customer acquisition, or market share. Use these projections to estimate the value of their contribution.





Negotiate and Discuss : Engage in open and transparent discussions with the resource to understand their expectations and negotiate a fair royalty percentage. Consider their level of risk, time commitment, and the potential upside for their efforts. Strive for a mutually beneficial agreement that both parties find acceptable.




Example #1 : If a resource typically charges a fixed fee for their service, say $5,000 for a basic branding package, under a deferred royalty-based compensation arrangement, it is appropriate to agree to a multiple of the fee, such as 2X ($10,000) or 3X ($15,000) to compensate for the risk that the business may fail to meet their revenue goals and be unable to pay the resource.



Example #2 : If a resource’s impact has the potential to generate $500,000 in additional revenue for the business, then a percentage of the potential revenue gains, say 20 to 30% of the $500,000 ($100,000 to $150,000) could be allocated to the resource since without their contribution, the business would have not received the additional revenue. This is known as a value-based fee .



Example #3: If the resource provides ongoing support to the business to assist the founder until the business achieves sufficient profit to compensate the resource based on their standard fee structure, under a deferred royalty-based compensation arrangement, they may be entitled to a percentage of all future revenue with no cap. This aligns the interests of the resource with those of the founders. That said, if after several years they are no longer involved in the business, the royalty percentage may decrease over time.



Define the Royalty Duration or Cap



Specify the duration or cap during which royalties will be paid. Since the founder and the resource do not want to be co-owners and the resource has been engaged to assist the founder during the pre-revenue stage, limiting the royalty period or amount is reasonable. Consider factors such as the expected time it will take for their efforts to yield results and any milestones associated with their involvement.



Defining the royalty duration or cap depends on various factors and considerations. Here are some steps to help you determine an appropriate royalty duration or cap:




Assess the Scope of Contribution : Evaluate the nature and extent of the resource’s contribution to your business. Consider whether their involvement is limited to the initial pre-revenue phase, or whether it extends to ongoing activities. The duration or cap should align with the time required to realize the benefits of their contribution, plus a risk premium.





Projected Impact : Estimate the timeline for the resource’s efforts to yield significant results or have an impact on your business. This could involve considering the time it takes for marketing campaigns to generate a measurable return on investment, or for initial setup efforts to establish a solid business foundation. Balance this projection with the resource’s level of involvement and their expected impact.





Milestone-Based Approach : Consider structuring the royalty duration or cap based on achieving specific milestones or goals if possible. For example, you can agree to pay royalties for a certain period or until the business achieves a certain revenue target, customer base, or market share. This approach ensures that the royalty duration or cap is directly linked to the achievement of predefined objectives.





Negotiate and Align Expectations : Engage in discussions with the resource involved to understand their expectations and negotiate a royalty duration or cap that is acceptable to both parties. Consider their time commitment, ongoing involvement, and the potential timeline for their contributions to bear fruit. Seek alignment on the duration or cap to avoid any misunderstandings or disputes later on.





Regular Reviews : Build provisions into your agreement to periodically review the royalty duration or cap. This allows flexibility in adjusting the royalty duration or the cap based on your business’s progress and changing circumstances. Regular reviews ensure that the duration or cap remains fair and relevant as your business evolves.





Legal Documentation : It is crucial to have a formal agreement in place that clearly defines the royalty duration or cap. You may want to consult with a legal professional to draft the agreement, incorporating the agreed-upon duration, payment cap, any milestone-based triggers, and provisions for potential adjustments or extensions. A sample legal document is discussed later in this post .




Define a Gradual Decline of Royalties Over Time



To address the situation where the resource is no longer associated with the company after its initial work, you can incorporate a gradual decrease in royalty payments over time. This decline could be tied to specific milestones or a predetermined timeline.



Implementing a gradual decline in royalty payments can be done in various ways. Here are some approaches you can consider:




Time-Based Decline : Agree on a fixed timeline during which royalty payments will gradually decrease. For example, you can establish that the royalty percentage will remain in force for two years and then decrease by a certain percentage every six months until it reaches zero after a specified period. This allows for a gradual transition as the resource’s initial work becomes less directly impactful to the business over time.





Revenue-Based Decline : Consider tying the decline of royalty payments to specific revenue milestones or performance targets. For instance, you could establish that the royalty percentage decreases as the business achieves certain revenue thresholds. This approach aligns the decline with the business’s growth and success, ensuring that the resource’s compensation reflects its ongoing impact.





Contribution-Based Decline : If the resource’s involvement has a clearly defined scope or deliverables, you can structure the decline based on the completion of their specific contributions. Once their work or project is completed, the royalty percentage can gradually decline or cease entirely. This approach acknowledges that their initial efforts are finite and that their ongoing involvement may no longer be required.





Gradual Scaling : Instead of a fixed decline, you can agree on a scaling structure where the royalty percentage gradually decreases over time but remains at a reduced level for an extended period. For example, the royalty may decline by a certain percentage initially but then maintain a lower, steady percentage for an extended duration. This allows the resource to continue receiving compensation but at a reduced rate.





Negotiation and Flexibility : It’s essential to have open discussions and negotiate the decline structure with the resource involved. Consider their expectations, impact duration, and the ongoing value they bring to the business. Be flexible and willing to adjust the decline structure based on changing circumstances or additional contributions they may make in the future.





Document the Decline Structure : Clearly document the agreed-upon decline structure in a formal agreement between both parties. This ensures that both parties have a clear understanding of how the royalty payments will decrease over time and minimizes the chances of any misinterpretation or disputes later on.




Define Contribution Metrics



Establish clear metrics or milestones that define the resource’s contribution. This will help determine the amount of royalty they receive based on the business’s success. For instance, you could base the royalty on the revenue achieved from the leads they’ve generated or the specific marketing campaigns they’ve executed.



Defining contribution metrics ensures transparency and aligns expectations between all parties involved. Here are steps to help you define contribution metrics:




Identify Key Result Areas : Identify the key areas where the resource’s contributions will significantly impact the success of your business. These can include specific marketing initiatives, lead generation, sales targets, customer acquisition, product launches, or other relevant aspects. These areas should be directly tied to the resource’s expertise and responsibilities.





Set Specific Goals and Objectives : Establish specific, measurable, achievable, relevant, and time-bound (SMART) goals for each identified key result area. Clearly define what constitutes success for each goal and provide quantifiable metrics that can be used to measure progress and evaluate the resource’s contribution.





Establish Performance Indicators : Identify key performance indicators (KPIs) that will be used to assess the resource’s performance in each key result area. These KPIs should be relevant to your business objectives and directly linked to the resource’s responsibilities. KPIs could include conversion rates, revenue generated, customer retention rates, website traffic, or social media engagement metrics.





Quantify Targets : Assign specific numeric targets or benchmarks to each performance indicator. These targets should be challenging yet attainable. They provide a basis for evaluating the resource’s performance and determining the corresponding royalty payments.





Define Reporting and Evaluation Processes : Establish a process for regularly reporting and evaluating the resource’s contribution. Determine the frequency and format of progress reports or performance reviews. Specify how the resource will provide updates on their activities, share relevant data, and demonstrate the impact of their efforts.





Incorporate Quality or Impact Assessment : In addition to quantitative metrics , consider including qualitative assessments or impact evaluation criteria. This can help capture the resource’s contributions that may not be easily quantifiable but still significantly positively affect the business. For example, client testimonials, customer satisfaction surveys, or stakeholder feedback can provide insights into their contributions.





Legal Documentation : Ensure that the contribution metrics, goals, targets, and evaluation processes are clearly documented in the formal agreement between both parties. This helps to avoid any ambiguity and provides a reference point for future discussions or disputes.




Create the Legal Contract



Here’s an outline for the legal documentation that can help control the engagement and establish clear terms and conditions:



Introduction




Parties Involved : Provide the legal names and addresses of the parties entering into the agreement.





Purpose : Clearly state the purpose of the agreement, which is to outline the terms and conditions governing the engagement of a deferred royalty-based compensation agreement.




Scope of Engagement




Description of Services : Detail the specific services or tasks the resource will undertake to assist the business.



Timeline : Specify the expected engagement start and end dates, or define the duration based on specific milestones or deliverables.




Compensation and Royalty Structure




Royalty Percentage : Clearly state the agreed-upon royalty percentage the resource will be entitled to, based on the business’s future success.



Decline or Cap Mechanism : Outline how the royalty payments will be capped or progressively reduced over time or according to specific triggers such as milestones, time, or completion of initial work.



Payment Terms : Specify the frequency and method of royalty payments and any reporting or documentation requirements for calculating and distributing the payments.




Contribution Metrics and Evaluation




Defined Metrics : List and describe the contribution metrics, key result areas, goals, and performance indicators that will be used to evaluate the resource’s contribution.



Reporting and Evaluation : Explain the reporting and evaluation process, including the frequency and format of progress reports or performance reviews. Detail how the resource will provide updates, share relevant data, and demonstrate the impact of their efforts.




Intellectual Property




Ownership : Clarify the ownership of any intellectual property created or developed during the engagement, ensuring that it belongs to the business and not to the resource.



Confidentiality : Include a confidentiality clause to protect sensitive information shared during the engagement and outline the obligations of both parties to maintain confidentiality.




Termination




Termination Clause : Specify the conditions under which either party can terminate the agreement, including any notice periods or obligations upon termination.



Transition of Responsibilities : Outline how the transition of responsibilities will be handled if the engagement is terminated.




Governing Law and Dispute Resolution




Choice of Law : Indicate the jurisdiction and laws that will govern the interpretation and enforcement of the agreement.



Dispute Resolution : Specify the preferred method of resolving disputes, such as negotiation, mediation, or arbitration , and include any relevant procedures to follow.




Miscellaneous




Entire Agreement : State that the agreement represents the entire understanding between the parties and supersedes any prior agreements or understandings.



Amendments : Describe the procedure for amending the agreement and the conditions under which such amendments are valid.



Severability : Include a clause stating that if any provision of the agreement is found to be invalid or unenforceable, the remaining provisions will remain in full force and effect.




Signatures



Provide space for the authorized representatives of both parties to sign and date the agreement.



Conclusion



In conclusion, many first-time small business owners lack the necessary business acumen and are undercapitalized. A deferred royalty-based compensation strategy can offer a potential solution to secure the necessary resources to launch a successful venture. By creating a payment arrangement based on future business revenue, these founders can compensate resources for their contributions without diluting ownership or hiring expensive talent during the pre-revenue phase of the business. Establishing such a strategy involves determining a fair royalty percentage, defining the royalty duration, implementing a gradual decline in royalty payments, defining contribution metrics, and creating a comprehensive legal contract. By carefully considering these factors and engaging in open negotiations, small business founders can structure a deferred royalty-based compensation strategy that aligns the interests of all parties involved and provides a pathway to success.



Is a deferred royalty-based compensation strategy an option for your new venture? The post How To Establish Deferred Royalty-Based Compensation for Undercapitalized Businesses first appeared on SteveBizBlog .