Tom Carr
Partner | Complex Securities Valuation
Connect with TomRoyalty financing has emerged as an increasingly attractive capital solution, particularly in industries characterized by high upfront investment and uncertain commercialization outcomes. While these structures can offer aligned incentives and non-dilutive funding, they introduce considerable valuation complexity and challenges due to performance-based and contingent payouts, embedded optionality, and path dependency.
Royalty arrangements offer flexible and attractive financing solutions, at the potential cost of accounting and valuation complexity.
This article outlines how practitioners can approach the valuation of royalty arrangements in accordance with best practices, highlighting when advanced techniques such as Monte Carlo simulation are necessary and when simpler approaches may suffice. We also step through an illustrative example of a royalty arrangement that is typical of what we often see in practice.
Capital in exchange for future revenue and contingent payoffs
A royalty arrangement is a type of financing agreement where investors provide capital to an operating company in exchange for a percentage of the company’s future revenue stream or streams, and/or specified contingent payoffs upon the achievement of various milestones.
Non-dilutive for the company, performance-linked for the investor
Structuring the financing in such a way can be beneficial for both parties. For the company, it provides immediate access to necessary capital without diluting the ownership stake of existing shareholders. For the investor, it offers a potential steady income stream and defined payoff that is directly tied to the performance of the product being financed.
Long timelines, heavy capital, uncertain revenue
Royalty financing arrangements are particularly common in industries such as pharmaceuticals, biotechnology, life sciences, and technology. This is often due to significant capital requirements, long development timelines, and highly uncertain revenues which may be dependent upon successful development, regulatory approval, marketing, and commercialization.
Fixed, tiered, or sliding-scale, plus milestones
Under a royalty financing arrangement, investors may be entitled to receive an agreed fixed, tiered, or sliding-scale percentage of revenue. Specified contractual payments may also become due and payable to the investor upon the achievement of predetermined milestones.
The royalty payments typically continue for a specified period of time or until certain criteria are met, commonly resulting in the initial investment being repaid along with a contractual additional return, or multiple.
The terms vary widely, and the terms drive the value
It is important to note that the specifics of any royalty arrangement can vary widely and will depend on the negotiations between the company and the investor. These agreements should be carefully reviewed to ensure clarity on aspects such as the duration of the royalty payments, the calculation of revenue royalty payments, and any provisions that result in acceleration or adjustments to the agreement over time.
For example, often there is a provision in the agreement that if the company has a Change of Control or an event in which the business changes drastically, the company must immediately pay a specified multiple of or return on invested capital. Certain agreements have minimum returns (floors), whereas others involve maximum returns (caps). Some agreements have call and/or put features. Others involve milestone-based capital outlays from investors to the company over a period of time.
Before diving into the illustrative example, it is important to establish a high-level understanding of the valuation methodologies considered and utilized.
We often consider most appropriate a hybrid approach combining the Discounted Cash Flow method and Monte Carlo Simulation. MCS offers a robust framework for capturing the complexity and variability inherent in contingent or performance-based arrangements. Its ability to model a wide range of outcomes and incorporate probabilistic assumptions makes it particularly well-suited for tiered structures, sliding scales, or other non-linear payout mechanisms.
Not all situations warrant the sophistication of MCS. For simpler arrangements, such as those involving a flat percentage of revenue without performance tiers or thresholds, a DCF approach may be more appropriate. DCF provides a straightforward and transparent method for estimating value when the underlying cash flows are relatively predictable and linear.
Embedded derivatives may arise where payment terms are linked to underlying variables such as market performance or financial metrics. Entities may consider electing the Fair Value Option to simplify accounting and reduce the need for bifurcation. The FVO can streamline reporting and align valuation with market-based measures, but it also introduces volatility to the income statement and requires careful consideration of the trade-offs involved.
CFGI’s finance and accounting advisory specialists assist many of our clients with assessing the appropriate accounting treatment for similar structures.
Consider a small pharmaceutical company, InfiniCure Inc., which has developed a promising new drug, Curaplaxin. InfiniCure requires additional funding to complete the final phase of clinical trials, secure regulatory approvals, manufacture, and market the drug, but wants to avoid diluting ownership through equity financing or taking on additional convertible debt. LifeFund Capital Partners has agreed to provide up to $100.0 million in funding, $20.0 million of which is contingent upon InfiniCure securing regulatory approval of Curaplaxin.
5.0% (the “Tier 1 Rate”) of calendar year net sales of Curaplaxin up to $250.0 million, and 2.0% (the “Tier 2 Rate”) of Net Sales in excess of $250.0 million.
If InfiniCure receives the Second Payment, the Tier 1 and Tier 2 Rates increase to 7.5% and 4.0%, respectively.
The maximum and minimum total payment amount from InfiniCure to LifeFund is a 2.75x multiple of invested capital (“MOIC”) and 1.15x MOIC, respectively, depending on Net Sales performance and the Buyout Option.
Royalty payments are made quarterly, based on net sales received by InfiniCure from Curaplaxin sales.
Payments continue until the earliest of: the payment cap being reached, a maximum term of 10 years from the Closing Date (the “Maturity Date”), or the Buyout Option being exercised.
Put/Call Option: LifeFund and InfiniCure each have the option to call/put the Investment in the event of (i) a Change of Control of InfiniCure or (ii) a contractual Event of Default.
Put/Call Payment: calculated on the Investment Amount funded, net of all previous royalty payments:
LifeFund receives a first lien, senior secured interest on all assets of InfiniCure, senior to all current and future equity, debt, or other obligations.
Assuming a Closing Date of June 30, 2025, and that the arrangement was negotiated in good faith as an arms-length transaction between unrelated parties, an implied discount rate can be derived which reconciles the fair value of the royalty with the $80.0 million in proceeds received by InfiniCure at Closing. As a component of this calibration analysis, we may also consider the probability-weighted present value of the incremental $20.0 million to which InfiniCure is eligible if Regulatory Approval is achieved. The Put and Call options would only be exercised if economically optimal and in connection with a Change of Control event.
75% probability of Regulatory Approval occurring on or about 12/31/2026.
10% probability of a Change of Control on or about 3/31/2027, 15% on or about 9/30/2028, and 5% on or about 12/31/2030.
If Regulatory Approval does not occur, a 65% probability of an Event of Default on or about 3/31/2027 and a 15% probability on or about 12/31/2027.
In this case, the Fair Value Option was not elected by company management, and therefore the valuation scope includes the bifurcation of the Embedded Derivatives.
A hybrid approach combining the DCF method and MCS is optimal here, given the non-linear and path-dependent nature of the royalties and the various potential scenarios for Regulatory Approval, a Change of Control event, and an Event of Default.
Consistent with the appraisal industry’s best practices, the fair value of the Embedded Derivatives is estimated using the “With and Without” method: valuing the royalty arrangement (i) inclusive of all terms, features, and conditions, and (ii) exclusive of the benefits provided by the Embedded Derivatives. The difference between the two is inferred to represent the fair value of the Embedded Derivatives.
Given the presence of tiered, non-linear payoffs and path dependency, MCS is used to simulate Net Sales, in alignment with the Appraisal Foundation’s guidance on the valuation of contingent consideration. Geometric Brownian Motion is applied to simulate Net Sales based on InfiniCure’s scenario-specific projections, an estimated Net Sales discount rate, and an estimated Net Sales volatility. These estimates are derived from observable historical revenue data for a cohort of revenue-generating guideline public companies comparable to InfiniCure.
Because the transaction is considered arm’s-length, an implied discount rate can be derived through a backsolve approach, solving for the rate that equates the present value of expected future cash flows to the proceeds received on the transaction date. The derived yield reflects a market participant’s expectations on that date.
This implied rate serves as a critical input and is calibrated over time to reflect changes in market conditions, the company’s creditworthiness, nonperformance risk, and similar factors. Calibration ensures the valuation remains aligned with observable data and consistent with the underlying assumptions of the royalty.
To account for the variability of the inputs and assumptions, approximately 500,000 iterations of the MCS are run, generating that many random paths for Net Sales and the events that can occur. In each iteration, three random numbers determine if and when (i) Regulatory Approval, (ii) a Change of Control, and (iii) an Event of Default occur, based on management’s estimated probabilities and timelines.
At each quarter end the model determines the royalty payment made, whether the Second Payment is deployed and the Tier rates adjusted, whether exercising the call or put is advantageous for either party, and the maturity payment if the 1.15x MOIC floor has not been met. The fair value of the arrangement equals the mean present value of the total payment amount across all iterations. The Embedded Derivatives are then extracted by disabling their economic benefits, repeating the simulation, and subtracting the “without” value from the “with” value.
At CFGI, our complex securities team has deep experience with royalty arrangements and embedded derivatives, and consistently delivers audit-ready valuations that are:
We aim to employ a reasonable methodology in accordance with customary industry standards, contemplating all salient contractual terms, conditions, and economics, all reasonably possible outcomes, and all salient risk factors. Methodologies may include Monte Carlo simulations, probability-weighted expected return (PWERM) or scenario-based methods (SBM), binomial lattice models, variations of Black-Scholes models, discounted cash flows, and code-based solutions. We proactively search for and resolve inappropriate assumptions and mechanics, calculation errors, and other barriers to accurate and supportable valuations, and we align upfront with our clients’ auditors on the proposed approach to minimize the risk of late filings, restatements, delays, and cost overruns.
We aim to provide deliverables that include all salient information necessary for both informed and uninformed readers to understand the instrument and the background to its negotiation and issuance, the methodology employed and the rationale for it, the mechanics used in the model and any key deviations from standard practice, and the key input assumptions and the rationale behind them.
We aim to provide deliverables that are neat, visually appealing, and consistent with CFGI marketing materials, free of typos and grammatical errors, and easy to follow for both informed and uninformed readers. While more information is nearly always preferred over less, we work to minimize clutter and ensure the reader can follow the salient points, support, and conclusions.
We aim to execute our valuations in a professional and workmanlike manner, and to deliver on schedules that empower our clients to meet their financial reporting, tax, or other deadlines. We have a deep bench of talented and experienced professionals who specialize in complex securities valuations, ensuring we can start and complete projects quickly.
For assistance with valuing royalty arrangements and their embedded derivatives, please feel free to contact our experts on the Complex Securities Valuation team.
Partner | Complex Securities Valuation
Connect with TomSenior Manager | Complex Securities Valuation
Connect with SteveA thoughtful, well-calibrated approach grounded in market data and aligned with ASC 820 principles is essential for producing defensible fair value estimates and ensuring a smooth audit review process.