Conflicts of Interest

The Choices made by Corporate Executives

Investors increasingly distrust profit projections made by corporate executives. This is partly because of inherent conflicts between the priorities of management and the interests of shareholders.

This article details some of these conflicts of interest, and suggests possible solutions. The use of royalty entitlements, or revenue sharing, is highlighted as a possible solution in each case. Royalties may better protect the independence of management, as well as the interests of investors, than traditional equity investment.

  1. Corporate executives of investor-owned companies naturally seek the greatest possible personal benefit. The cost of their salaries, bonuses, stock options, pension plans and perks come at the expense of shareholders.

Solution: Royalty owners are only interested in the revenues of the company. As long as revenues increase, management compensation can be designed as needed, within reasonable bounds.

  1. Company executives cannot always control the costs of producing the company’s products or services, the costs of marketing, meeting competitive pricing pressures, the costs of research and development — and many other expenses which may be needed to advance the company’s long-term future, or deal with supply or pricing issues. So margins may temporarily decline, the company then reports lower profits, and the value of shareholders’ investments, tied directly to the reported P/E ratio and other measures of profitability, also declines.

Solution: Unlike equity shareholders, royalty owners are only interested — and only benefit from — increased revenues, not from reported profitability or profit margins.

  1. Senior executives often need to seek shareholder approval for legal, tax and other actions that they believe to be in the company’s best interest. This can be a time-consuming and difficult political process.

Solution: Royalty holders do not have a right to vote on company matters, so management does not need to ask their opinion. Management decisions will almost always seek to maximize revenues, so their interests will, in most cases, be efficiently aligned with those of royalty holders.

  1. Company managers, particularly in privately owned companies, often take advantage of tax strategies and various accounting methods to reduce the level of reported profitability. This may allow them to avoid paying dividends or profit sharing to shareholders, and adversely affects the interests of investors.

Solution: Royalty owners have no interest in the level of reported profitability or dividend payment policies. Their only immediate interest is in the company’s revenues, and in the company’s continued ability to pay royalties as agreed.

  1. Owners of stock in companies have two main ways of benefitting from the success of their investments: first, they may be able to sell their shares for more than they paid for them, at some future date — or second, they can hope that the company will one day pay dividends — usually based on a percentage of reported profit. Their return on investment may be long deferred, and uncertain.

Solution: Royalty owners can receive their agreed percentage of revenues on a regular basis — paid quarterly or monthly, and accruing daily. They begin to benefit as soon as their investment is received by the company. Their return is not indefinitely deferred, and its course is much more certain. The cost of capital to management is also much more easily quantified (a simple percentage of top-line revenues), rather than loosely diffused as future obligations to shareholders.

From the perspective of those investing in a business, royalties deserve serious scrutiny as an option for providing predictable returns. From the perspective of those managing a business, royalties are of interest since they allow management to maintain independence.

For everyone involved, royalties are easier to understand and measure than equity investments.

Arthur Lipper, Chairman

British Far East Holdings Ltd.

April 23, 2013

with the assistance of Michael North