Royalties

Related Terms: Licensing; Royalty Financing

Royalties are payments made by one company (the licensee) to another company (the licensor) in exchange for the right to use intellectual property or physical assets owned by the licensor. For example, software giant Microsoft invented the Windows operating system for personal computers as a means of managing files and performing operations. Computer manufacturers such as IBM and Compaq pay a royalty to Microsoft in exchange for being allowed to use the Windows operating system in their computers. Other common situations in which royalties are paid include the following:

1. In the fashion industry, designers such as Ralph Lauren and Calvin Klein license the right to use their names on items of clothing in exchange for royalties. For example, they may sign a contract with a company that makes jeans that allows the company to place the designer's name on the jeans.
2. In book publishing, authors are commonly paid an advance on future royalties based on percentage of sales price; after sufficient sales have been made to "pay back" the advance, the authors received additional royalties paid periodically.
3. In the music industry, royalties are paid to music copyright holders and to songwriters by radio stations and anyone else who derives a commercial benefit from the copyrighted material.
4. In the television industry, popular satellite TV services such as Direct TV and cable television services pay network stations and superstations a royalty rate so that they can broadcast those channels over their systems.
5. In the oil and gas industry, companies pay landowners a royalty rate for the right to extract natural resources, such as petroleum and natural gas, from the landowner's property. Similar agreements exist in the mining industry for minerals such as copper and silver.

HOW RATES ARE ESTABLISHED

Royalty agreements are intended to benefit both the licensor (the person receiving the royalty) and the licensee (the person paying the royalty). For the licensor, signing a royalty agreement to allow another company to use its product or intellectual property can mean expanding into a new market, or increasing market share in an existing market. For the licensee, the agreement can mean gaining access to products that may have been too expensive or too difficult to produce on its own, or that were protected by patents it did not own. If done right, the royalty arrangement is a win-win situation.

Royalty agreements generally are one of two types. The fixed price-per-unit agreement pays the licensor a set price for every one of its products sold by the licensee. Often, this type of agreement is used when the licensor's product is one that will be a small part of a larger product produced by the licensee. An example of this might be a new type of windshield wiper motor developed by Company A. The motor drastically changes the way windshield wipers work and is granted a patent by the U.S. Patent Office. Company A approaches BBB Autos and offers to license the motor to the automaker so that it can be included in all BBB cars and trucks. In return, BBB agrees to pay Company A $10 per unit for every motor it purchases. This price would cover the materials and labor needed to produce the motor, as well as include an extra sum to cover Company's A investment in developing the motor. In fixed price arrangements, the amount per unit can be adjusted for inflation, or a minimum royalty amount can be specified.

The second type of agreement is a royalty that pays a percentage of revenues or operating profit that results from the sale of the licensed product. This is more likely to be used when the item covered by the royalty agreement stands alone or when the cost of using the item can be clearly itemized. Percentage agreements are generally more intricate than fixed price agreements because more terms must be defined—what rate will be paid for discounted items, what happens to items that are returned, whether sales commissions affect the percentage paid, whether updated versions of the item are covered by the agreement, and more. Agreements based on a percentage of the operating profit generally result in a more equitable settlement for both parties, but those agreements are also more complicated. As a result, it is more common for companies to agree on a percentage of revenues.

In percentage agreements, it is essential that the percentage chosen be fair to both sides. There are three areas to consider when determining a rate: 1) the specifications of the actual product or intellectual property being licensed; 2) the length and the geographic scope of the agreement; and 3) the capabilities of the licensor and licensee to live up to the agreement.

Factors related to the product that can affect the agreement include the uniqueness of the product, including any patents that may be included as well as any new versions of the product that may or may not be included in the agreement; the markets in which the product will be sold; and whether or not the product needs to be customized to meet the needs of the licensee. If customization is required, then the licensee should pay the licensor a higher percentage to cover additional manufacturing costs.

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