The Hidden Risk of Royalty Exchange Music Investing

Royalty Exchange is a platform that exists to permit amateur and professional investors alike the opportunity to purchase the royalty rights from musicians that seek to sell the residual earnings claims / digital rights. It has found early success by tapping into attractive concepts—the desire for regular income and the desire to own an asset that provides psychological satisfaction in a way that investing in, say, sewage dumps and funeral homes cannot.

Unfortunately, the ease of purchasing music royalties enables royalty purchasers to dramatically overvalue the worth of the royalty stream due to naivete with the industry.

For instance, someone might see a royalty exchange listing for an indie band that earned $7,000 over the past year and conclude that $35,000 is a reasonable price to pay (based on my review of the ten most recent listings on the royalty exchange website, the average price paid was about 5x earnings). While this type of logic sounds reasonable, it completely ignores the extreme depreciation that characterizes the nature of music.

Studies of music as a capital asset have indicated that 75% of the expected royalty income occurs during the first year after the release, depreciates at a 10% annual rate between years one and five, and then approaches near-zero (i.e. annual royalty payments of less than $750) from year six onward.

This means that by the time a royalty is made available for sale, most of the immediate income has already been generated for the owner of the musical asset, and the seller is hoping that an optimistic buyer will perform an analysis that overly expects the first-year data to continue during the course of the post-sale ownership.

But this is not what I consider to be the hidden risk of using the website Royalty Exchange—after all, it is in the market of selling music assets, and it would be unfair to blame a broker for the underlying economics of the industry.

What I regard as the hidden risk of making royalty purchases through this website is the extent to which it permits the sellers of royalties to utilize the “buyback option” clause that is, yes, included in the terms of the offer but is not particularly conspicuous when considered against the amateur class of investors that are able to frequent the site.

If you ever buy a royalty stream from a musician after the first year of sale, there are only three ways that you have a realistic shot of earning a profit:

  1. The artist releases new material that is popular with a larger audience and, as a result, the enlarged audience revisits the artist’s earlier material that you now own.
  2. The artist experiences a unique event that results in the widespread adoption of a song, such as a TV sitcom or commercial electing to use the song and make a royalty payment for each use.
  3. The artist dies or something happens that triggers nostalgia and re-establishment of the artist’s relevance temporarily.

The realization of one of those options is the only credible chance that a music royalty investor has of earning a profit.

When the seller includes a “buyback option” clause in the sale contract, often saying something like “The seller reserves the right to purchase this royalty at 125% of the purchase price at any time within five years of the date of sale hereof”, the seller is recapturing the upside and offloading all of the risk onto the buyer.

A buyback option effectively destroys even the low-probability possibility of making money by investing in music royalties. The buyer of the royalty will find himself on the path of owning that near-immediately depreciated 75% income stream, but if anything happens that indicates that a meaningful profit can be realized, the seller can hop right back in and capture the upside.

It is excellent contract for sale drafting by the seller of the royalties. But, considering that royalty exchange is also trying to appeal to the purchaser of the royalties, it should consider a policy of either bolding and clearly explaining the effect of these buyback repurchase provisions or ban sellers from the site that attempt to utilize the buyback option (in much the same way the New York Stock Exchange will refuse to list a company that does not have any outside, independent directors on the Board).

My own analysis is that naïve customers are purchasing royalties without analyzing the full import of these buyback options. When I see a royalty stream that has generated $5,000 in the past year up for sale with a seller’s buyback option, my calculation of fair value for the royalty is somewhere around $1,500-$2,500. When I see the actual royalty sell for somewhere in the $22,000-$32,000 range, the only conclusion I can reach is that the buyers are not reading the buyback clause or are not properly weighing it.

From a seller’s perspective, a buyback option is fantastic because it lets you reclaim ownership (often at a de minimis premium) in the event that the asset sold turns out to generate high profits down the road. If it fails to do so, hey, you already got your money and you don’t have to exercise the option.

But from the buyer’s option, there are very few attractive scenarios for the purchase. I suppose it is theoretically possible that the royalties could sky-rocket for one of the above-referenced reasons and the seller somehow fails to exercise the buyback option, but relying on the other side to a transaction to be stupid is not a thoughtful investment strategy.

This leaves the buyer hoping for modest gains—but not too good to catch the attention of the seller sitting on the buyback option—such that the risk proposition is something to the effect of, “I have an 80% chance of losing money on this, a 15% chance of earning 3-4% annual returns, and a 5% chance of getting bought out for $1.25 on the dollar for a one-time 25% gain in a best-case scenario.”

As a general matter, I do welcome the democratization of exclusive institutions and the creation of opportunities for small investors to have a mechanism for one day becoming large investors. But music is a terrible asset to own for the long-term in nearly all instances, unless you created something out of nothing that somehow proves timeless, and the fact that Royalty Exchange is permitting all of these sales of music with buyback options makes me question the usefulness of the business model when viewed from the buyer’s perspective.

Originally posted 2018-02-03 10:20:05.

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