Recently, I wrote about two different payment models for engineering services: time & materials and fixed price. I briefly mentioned the concept of using a promise of downstream participation in a product’s sales as a way to compensate the provider of engineering services.
At Cardinal Peak, we are willing to include royalties as part of our compensation under certain circumstances, but there are powerful constraints limiting our appetite for such deals. So in this post, I’ll explain a few of our reservations about royalties.
From the customer’s perspective, the idea of compensating an engineering services provider like Cardinal Peak through royalties has two attractions. One, it can reduce the up-front cost and create a situation where both risk and reward are shared between the customer and Cardinal Peak. And two, which is related, the idea is that the royalty can make Cardinal Peak feel more committed to the customer’s business success.
Clearly, the effect on Cardinal Peak of depending on royalties for part of our compensation is to force us to share in the customer’s business risk — in other words, to bet on the customer’s success. Although a royalty stream can clearly be structured in such a way that Cardinal Peak’s potential return is greater than it would be under a T&M model, it is important to bear in mind that we have little or no ability to affect the customer’s business risk. This naturally limits our willingness to make this bet.
We don’t run the customer. We don’t sit on the customer’s board and the customer won’t be calling us for business advice. For example, we cannot affect how many salespeople the customer hires, how much it spends on marketing, how much money it raises from investors, which deals it chooses to pursue, which products it chooses to develop, which markets it targets with the product we designed for them and so forth. There is even the risk that the customer decides at some point after introducing “our” product that it would rather focus the bulk of its effort on some other product or market that doesn’t result in a royalty payment to us.
Finally, there are practical difficulties associated with negotiating royalty streams. For example, are they time-limited or tied to the number of units sold? Are they associated with specific products or are they a fixed percentage of the customer’s total revenue stream? Do royalties also apply to derivatives of the initial product, even if the derivatives aren’t developed by Cardinal Peak? Often we know very little about the customer’s business situation and have never read their business plan (if they have one).
To make a long story short, there is usually so much we don’t know about the business, and so much we can’t control about how the customer is run, that our appetite for sharing the business risk — although definitely greater than zero — is finite. Needless to say, the more established the customer is in its market, and the longer its track record, the more willing we are to make this bet. But in my experience, the converse is also true: The more certain the customer is that the product will sell, the less likely they are to offer us a royalty.