Equities and royalties are both ways of generating wealth. But when it comes to equity vs royalty, which option is better, and why? We explored these two types of investments, and here’s what came out.
What Is an Equity?
Equity is the money shareholders will get if a firm is shut down, all of its assets are liquidated, and all of its debt is paid away.
If, instead of shutting down, the company is sold, then equity would be the value received from the sale after reducing any liabilities that are not transferred to the buyer.
A third way to look at it is the book value of the firm. Yet another definition from the accounting field is the Assets minus the Liabilities of any company.
In this sense, equity is a part of the balance sheet, and accountants and financial analysts use it as an indicator of the financial health of a business.
What Is an Example of Equity?
The simplest example of equity comes from the assets minus liabilities definition we described above. If a firm’s assets stand at $2mn and liabilities at $1.5mn, its equity is $0.5mn.
If this business were to be sold tomorrow and all its liabilities were paid using the proceeds, then the shareholders would receive $0.5mn in lieu of the investment they might have made in it.
What Is a Royalty?
A royalty is a payment made to either a company or an individual for the ongoing use of an asset owned by them.
Some examples of such royalty resources could be franchises, intellectual property, copyrighted works, natural resources, etc.
In a way, royalty can also be seen as a license payment. It confers the payer a right to use the asset temporarily, per the royalty agreement’s terms.
The most common form of royalty payment is the money given to musicians for using their soundtracks whenever they are played on any medium.
How Does a Royalty Work for a Company?
When a firm uses the intellectual property or assets of another to make a profit, it has to pay a royalty to the legal owner of the resource.
For example, a business might be using a technique patented by another and paying a royalty fee for it. This often happens in drug manufacturing.
Another common scenario is that of a franchisee using a firm’s logo, branding, and business model to generate revenues.
Depending on the agreement signed between the parties, the franchise owner could get payments as a flat fee, a percentage of profits, or a pay-per-use arrangement.
Such royalty agreements usually specify the nature of the resource, how and when it can be used, outlines the payment schedule, and lays out other terms and conditions.
What Is an Example of a Royalty?
Common examples of royalty payments to individuals include money paid for original material such as books or music.
Between businesses, royalty payments for franchising are another frequently occurring instance.
Another example is businesses paying royalties for using a natural resource to their owner.
One such case is payment for the rights to extract minerals from a mine located under land owned by someone else.
Equity vs Royalty: An In-Depth Comparison
When investors buy equity, they pay money to own a piece of the company’s future profits.
Similarly, when a firm pays royalty, it does it to get access to a resource that can help generate revenues for it.
In either case, a payment is made to acquire a valuable asset.
However, the similarities end here. The ownership, types, and payouts of equity vs royalty are very different from each other.
Ownership Criteria
Equity represents ownership of a piece of a company’s future revenue in lieu of investment capital.
On the other hand, royalty does not confer any ownership in such assets to the paying party.
Royalty is simply a fee to use an asset for a limited period or to a specified extent, as stipulated in the royalty contract. It does not transfer any claim over the underlying resource.
Categories (Types)
Equity can take many forms based on what kind of rights it confers upon the shareholders and the company’s obligations toward them.
Royalties are seen from the point of view of the underlying asset or resource that is being lent out as part of the agreement.
Types of Equity
Common stock
Common stock is the total value of the ownership of the company. It is calculated by multiplying the number of shares by the security’s par value.
Common stockholders can vote on important company matters and have certain ownership rights to their assets.
They can participate in board elections, determine dividend policies, and intervene in corporate governance-related issues.
Equity shareholders have limited liability protection from the firm’s creditors if it gets liquidated.
They also claim the company’s value after its obligations are paid off.
Preferred shares
These stocks are offered to investors instead of common shareholders.
Preferred stock usually has defined dividends and might have additional features like convertibility and call provisions to make it attractive to investors.
Additionally, preferred stockholders have higher precedence than common ones if the firm gets liquidated. Any obligations the firm might have towards them must be paid out.
These types of equity holders do not have any roles or responsibilities towards the firm, nor do they have voting rights in key matters.
Contributed surplus
Contributed surplus is additional money that investors pay if the stock goes above its par value.
It is also known as additional paid-up capital.
Retained earnings
Retained earnings are net incomes after dividend payout that can be reinvested in the business. It is the money left after all obligations are accounted for at the end of the year.
Treasury stock
If shares are bought back by the company and are no longer available for common stockholders, the value of such shares is called treasury stock.
Types of Royalties
Book royalties
Book royalty forms the key source of earnings for authors of books.
Their publishers offer them money, typically on every book sold, based on a pre-agreed amount or percentage of the book’s cover price.
Performance royalties
Artists and musicians copyright their creations so they can receive payment whenever it gets played or shown on any media (such as radio, TV, or movie).
There are certain private organizations, such as ASCAP or BMI, who specialize in performing rights and can collect such royalties on their behalf.
Patent royalties
Inventors might patent their creations so that anyone who wants to use them needs to pay a fee to access them.
Patent royalties, especially in the field of science, encourage innovation and ensure adequate compensation for creating new breakthroughs.
Franchise royalties
Many businesses, such as Mcdonald’s, only own some outlets which carry the famed golden arches on them.
Instead, they offer their business model, recipes, branding, and other assets to help franchisees set up their own branches under the McDonald’s name.
In return, McDonald’s takes a franchise fee from the franchisor, another royalty payment type.
Mineral royalties
Owners of resource-rich lands, such as places with coal or natural gas, charge a royalty for access to the property.
The firm that is interested in extracting the resource pays them a sum based either on revenue or units extracted (such as barrels of oil).
Payouts
While royalty income is usually in the form of money, equity is a non-cash form of payment.
It is either a share (in the case of listed companies) or a private company stock (when the firm is non-listed)
The equity stockholder might make money either through capital gains or dividends paid out on the stock.
Are Equities a Good Investment?
Yes, equities can be a good investment. Putting money in equity can be one way for investors looking to grow their money or earn regular dividend incomes.
However, equity only grows if the company performs well, so an inherent risk is involved.
If the firm’s business model is not good or faces headwinds due to external factors, the equity value can even go down.
Are Royalties a Good Investment?
Royalties are a good way to make long-term steady incomes. They are also a means to diversify a portfolio made primarily of stocks or bonds.
However, royalty payments are not correlated with stock market movements. They are a kind of guaranteed income, no matter how the firm may be doing.
Royalties also have associated risks. For example, if they are based on franchise revenue, a lot depends on how well the core brand performs.
If the franchise’s brand value diminishes, then fewer folks would be interested in taking a new franchisee, and therefore, royalties might fall over time.
Final Thoughts
Owning equity gives a potential for capital gains through long-term value appreciation, but it might be a risky investment if the firm does not do well in the future.
Royalties are a stable source of income but do not offer capital growth. They also have inherent risk, especially if the asset value they are based on depreciates with time.
Both can be a good way to invest money, depending on the risk appetite and strategy of the investor.
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