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Royalties or Equity?

Back in 1985, Modigliani and Miller won a Nobel Prize in Economics for showing that a company’s value was unaffected by its debt/equity ratio.   It didn’t matter, they said, how you divided the pie, the pie was still the same pie.

Which returned to mind this week when my colleague Charles Martin was advising an inventor whether he should seek royalties or equity in his project.  So – which is in fact best?

Fundamentally, both are flows of wealth leaving the business.  Imagine first a business with shareholders only.  The inventor is a shareholder and so receives his rewards as his % share of the dividend stream. 

Suppose he switched his shares for a royalty?  Wealth would now leave the business before dividends were paid, diminishing them by that amount.  Let’s take an example:

An inventor has 40% of the shares in a business making £1m sales and yielding 10% net profit (£100k).  So he gets £40k in dividends.  If he charged a royalty instead, a 4% royalty on sales would put him in the same place (4% of £1m = £40k).  The other shareholders would then get 100% of £60k profits.

So it’s a meaningless question?  Well not quite.  Time, risk and tax enter the picture.  Royalties arrive as soon as sales are made.  Dividends may delay – years if the profits are ploughed back in – but then may be much larger.   Royalties depend only on sales, profits depend on costs too.   And the chancellor takes more of some forms of income, less of others. 

So the choice turns on your preferences in timing and risk, and on your tax situation.  Same pie, mind.