Residual Claimant

The Residual Claimant refers to the person or group receiving claims on residues like profits after meeting all obligations. The main objective of these claimants is to have the remaining claim on the leftover profits and assets. 

The primary role of residual claimants is seen in corporate finance and economics. They have a high chance of achieving high returns. Also, they are better at understanding business and its operations. In addition, they have a complete interest in the company. However, the residual claimants may earn less than the expected returns.

• A residual claimant is a person or a whole group with the last right to receive any profits left with the firm. Here, claimants cannot claim their share at the first stage.
• The concept originated in the early 20th century in the United States. In 1921, an American economist explained it in Risk, Uncertainty, and Profit.
• Here, the factors of production (like laborers, capitalists, landlords, and entrepreneurs) are entitled to receive residual claims. However, there is always a threat of residual risk.
• In 1875, Francis A. Walker gave the residual claimant theory of wages in the book Political Economy.

The residual claimant can be a person or entity entitled to get any residues in the form of profits or losses after clearing all the expenses. It has significant applications in agriculture, corporate finance, and economics. However, there are specific criticisms of residual claimant theory.

The concept of the residual claimant in economics was given by American economist Frank Knight in the book Risk, Uncertainty, and Profit in 1921. This book considered certain factors of residual claimant theory. It includes land, labor, capital, and entrepreneurship. However, in each case, the role of the residual claimant will be different. Regarding rental distribution, the landlords were the last ones to have residues. For example, agricultural land will have labor as the first deduction, followed by capitalist employers. In the end, the leftovers remain with the landlord.

Likewise, if capital is the prime factor, then the residual claimant of the company will be the capitalist or employer. The company pays the landlord the rent before distributing gross profits. Capitalist employers will pay labor (or employees) later. In the case of labor, the workers will benefit from residual claims. In 1875, American economist Francis A. Walker stated how laborers act as the last claimants. However, the multicriteria for the last factor differs totally.

Legal experts Frank Easterbrook and Daniel Fischel explained this theory in the book The Economic Structure of Corporate Law, published in 1985. They concluded that shareholders are the sole residual claimants of the company. However, another American legal scholar, Lynn Andrea Stout, argued for their theory. Stout pointed out that even if shareholders receive residues, it depends on directors whether to declare a dividend or not. As a result, it is only sometimes possible for them to receive a part of the profits.

Let us look at the examples of residual claims to understand the concept better:

Example #1

Consider John Scoops Ltd., a large-cap company vested in making ice creams. By the end of the financial year, the firm had earned $2,500 million in profits. However, this revenue needs accounting treatment. As a result, the firm will pay various expenses like wages, salaries, and rent to the respective factors. However, the adjusted earnings before interest, taxes, depreciation, and amortization (Adjusted EBITDA) were $5 million. Therefore, this amount was allocated to their shareholders. As a result, the final dividend declared was $0.40 per share. Thus, they become the residual claimants of the remaining residues.

Example #2

Suppose Alfred Gomez is a well-known landlord who recently bought a piece of real estate. He decided to lend it to a group of farmers who would grow crops on it. So, as per the contract, Gomez would take out a certain percentage of the yield. By the end of the season, farmers had a yield of $20,000. Out of it, 20% went to the respective farmers. Likewise, 10% went to estate taxes and expenses. And lastly, the rest of it (70%) rested with Gomez. Thus, he became the residual claimant when the land was the prime factor.

The residual claimant theory of wages was put forth by the American economist Francis Anessa Walker in 1875 in the book Political Economy. This theory states that after deducting all expenses for factors of production, the remainder goes to labor. As per the theory, rent and interest are compulsory payments. Thus, out of the total profits, rent and interest are deducted first. In the later stage, the employer will deduct its profit. As a result, the rest is wages.

So, if the laborers want to increase their wages, they must improve their efficiency. As a result, the total product will also rise. However, there is particular criticism of the residual claimant theory of wages. Let us look at them:

• Here, the claimant is the entrepreneur, not the laborer. The entrepreneur will first pay rent, interest, and wages. And if any remains, it will be in the pockets of the entrepreneur.
• The theory assumes that the shares of factors like entrepreneurs, landlords, and capitalists remain fixed. However, it differs in practicality.
• It needs to explain the influence and effect of trade unions while determining wage rates.
• Francis Walker's theory of wages fails to consider the supply of labor.

This has been a guide to Residual Claimant and its definition. Here, we explain the concept in detail with its theory of wages and examples. You can learn more about financing from the following articles –

• Liquidation
• Orderly Liquidation Value
• Company Dissolution