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I watch Shark Tank and very often find that people, when faced with either exchanging equity for capital, or keeping their equity and paying a royalty on product sales, very often (almost always) choose the non-royalty offer.

I'm trying to understand why that is. For example, just to play with some specific numbers, let's say a company is selling a product with a $50 profit margin per unit (on a $10 production cost), and I'm willing to give them $100,000 for 10% equity in the company or else give them the $100K for no equity and $2 per unit until my money is paid back, after which my royalty drops to $1 per unit in perpetuity. Far more often than not it appears to me that the capital for equity trade is the preferred offer.

When and why is it smarter to lose equity over taking on a royalty?

  • Side-note regarding "on-topicness": I havent asked on this site before and I'm not sure how strict it is here regarding questions being relevant to personal finance. While this is asked based on the perspective of the entrepreneur, it seems like the answer would be perfectly relevant to personal finance in the case of someone being interested in a friends-and-family investment deal and needing to understand this concept. – Viziionary Mar 13 '17 at 21:21
  • I'm not knowledgeable enough to answer equity vs royalty, but keep in mind that Shark Tank is a "reality" TV show, not a documentary. Most of the deals "made" on the show never come to fruition. It's for entertainment, not education. – Charles E. Grant Jan 30 at 17:50
  • The valuations people give on that show are mostly pulled out of thin air. Even if you get 100k for 10%, that doesn't mean your 90% is worth 900k. How will you find someone who wants to pay that price for your equity? So really, you are not choosing from royalty vs. equity, you are choosing between royalty vs. potentially worthless equity. Of course the royalty is a better choice. – Money Ann Feb 1 at 15:08
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Equity can be diluted by future investors, royalties get paid on each sale, companies can continue selling things even when operating at negative profit, back royalties due can be negotiated and at least partially paid in a bankruptcy.

From the standpoint of the investor: If it doesn't look like the company will likely have commercial success with a second product, it may be wise to simply take a portion of the product that is actually selling rather than risk your capital on the company's future successes (or failures).

From the standpoint of the business owner/entreprenuer, if you believe you have a second product close to the end of the development pipeline it would be wise not to give up equity in the entire enterprise simply to gain required financing to ramp up production and marketing on an existing product. Paying a royalty may be advantageous compared to paying interest on a loan as well (royalty payments are contingent on the occurrence of a sale while interest is due regardless).

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Don't forget the royalty is fixed and often times can be passed on to the consumer via price increase (often times a negligible amount). Even a portion of the fixed royalty can be mitigated with price increase. Another way to think about it is a royalty represents ownership in one particular product, whereas an equity stake represents ownership in the entire company. In the long run the equity stake can be very costly if the entrepreneur is building a brand versus a one-off invention.

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