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:
- 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.
- 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.
- 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.
- 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.
- 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.
As for the agreement itself, it should clearly state the duration and should include the terms under which termination will occur. Whether or not the agreement can be renewed if certain goals are met should also be clearly spelled out. If a contract is too restrictive, the licensor may find at the end of the contract that it has limited itself in such a way that it can only renew the agreement with the current licensee, at less desirable financial terms. To try to find a new partner would be too cost intensive, so the licensor must renew with the original licensee. In addition to duration, the agreement should spell out the geographic rights granted to the licensee—does the agreement cover U.S. sales only, or are international rights included? Finally, the agreement should have a provision to handle "third party assignment." That is, what happens if the licensee assigns the rights to the product to a third party, possibly as a means to lower production costs? In some cases, the contract is invalidated if a third party assignment occurs, so it is an important area to cover.
When approaching a licensor, a licensee should examine the company's business practices before signing an agreement. Things to watch for include the licensor's ability to keep up with technological advances and its financial stability. If the licensee feels there is a chance the licensor may not be able to keep up with industry shifts and may even go out of business during the life of the agreement, than the licensee should seek to negotiate more favorable royalty terms. The licensee should also expect the licensor to have a clear plan outlining research and development plans, goals for the product, and plans to develop new or related products that could possibly expand the agreement. Evidence of planning and clear goals for the future by the licensor should instill confidence in the licensee. Finally, does the licensor have the ability to provide the licensee (and consumers) with needed levels of customer service and support? This is especially important for high-tech products or for complex products. The better the support that is in place, the better the terms the licensor can expect to receive.
Conversely, the licensor should expect certain things from the licensee. Can the licensee live up to its promises as far as units sold and territory covered? Has the licensee sold products of this nature before, and does it have a strong history? Is the company financially viable, and does it show clear plans for future growth? Can the licensee offer something other than cash as part of the agreement—for example, does the licensee have the ability to enhance the original product with its own products, or does it offer the licensor a market credibility that was previously lacking? All of these situations can affect how much money the licensor expects in the royalty contract.
LICENSING INTELLECTUAL PROPERTY
Intellectual property owned by one company is considered to be an intangible asset of that company. An intangible asset is something abstract, such as a patent or copyright, as opposed to a tangible asset, such as a factory or manufacturing equipment, or even cash. Intellectual property will, of course, have a physical form. It is structured information which can be and is recorded. Xerography or the chemical content of an important drug are examples. They reflect real wealth.
The Internal Revenue Service of the United States has developed definitions of what qualifies as intellectual property and oversees the regulation of royalty payments involving intellectual property. Among the intangible assets that are considered to be intellectual property are:
- Patents, inventions, formulas, processes, or designs;
- Copyrights and artistic compositions, including books and music;
- Trademarks, trade names, or brand names;
- Franchises, licenses, or contracts;
- Items specifically compiled or created by a company, such as methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and
- Any other items that are not physical in nature, but rather intellectual.
Whenever any intangible assets that fit these criteria are sold or licensed from one company to another, a royalty must be paid. There are two types of transactions that may occur. The first involves the sale or license from one company to another, which is called a third-party transaction. In this type of transaction, Company A licenses the rights to its product or process to Company B, which pays a royalty rate for the right to use the product or process. This is the type of transaction that is most commonly thought of when royalties are considered. However, the second type of transaction, the intercompany transfer, is actually more common. The law in the U.S. makes it illegal for an American firm to transfer intellectual property rights to a foreign subsidiary unless royalties are paid. The IRS has very strict rules that it applies to all intercompany situations and has come up with a number of formulas that it uses to determine if a fair royalty rate is being paid.
The simplest formula used by the IRS is called the cost-based method. Using the cost-based method, a company can establish a royalty rate that recaptures the costs of developing the item that is being licensed while also providing a fair rate of return on the item. To use the cost-based method, a company must determine what it cost to develop the intellectual property, the life expectancy of the property, the total revenue generated by products that use the property, and a fair rate of return that will cover the risks the company took in developing the property.
The cost-based method is the most straightforward, but it has flaws that limit its effectiveness. In most cases, the costs of developing the intellectual property do not have a direct correlation to the actual value of the property, so the method will not produce accurate results. As a result, the most commonly used formula for determining a royalty rate is the "comparable uncontrolled transaction (CUT)" method. This method relies on historical data and the performance results for products or processes that are similar to the intellectual property that is being licensed. For example, a book publisher lining up an author to write a book may look at the rates that were paid to other authors to write similar books when they determine how much to pay an author for the new project. Similarly, a clothing designer may look at other licensing deals in the industry when it comes time to license his name for use on a line of handbags or accessories.
When applying the CUT method, the intellectual property in question can only be measured against other intellectual property that was used in similar products within the same basic industry or market, and that has similar profit potential. Additional factors, such as the length of the agreement, geographic restrictions, and the right to receive updates, also factor into determining if the CUT method can be utilized. The CUT method is preferred by the IRS and is used in most third-party licensing agreements.
Beyond the two most common methods of evaluating royalty rates, the IRS uses four other formulas that are less common. These include the comparable profits method (CPM), which compares the profits of companies that use the intellectual property in question to the profits of similar companies that do not use the intellectual property; the hybrid CPM, which uses a combination of the CUT method and the CPM method in order to take the profit-making potential of the intellectual property into account; the profit split method (PSM), which accounts for situations where the licensor takes the intellectual property and adds value to it through its own processes, thereby enhancing the profitability of the property at its own expense; and the residual market value (RMV) method, which recognizes that a company's financial performance can affect the value of intellectual property and thus uses stock market data to determine the estimated value of the intellectual property that is being licensed.
COPYRIGHTS, PATENTS, AND ROYALTIES
Perhaps the most common day-to-day application of royalties that most consumers can relate to involves those paid for the use of copyrighted material. Every time a song is played on the radio, a royalty fee is paid by the station for playing that song. Every time a cable television provider transmits the signal of a broadcast television channel, such as superstation WTBS out of Atlanta, it pays that station a royalty for the right to show it. Every book, magazine, and newspaper published in the United States is protected by a copyright, and royalties must be paid any time a portion of a print product is reproduced by anyone other than the publisher.
In the United States, several organizations are involved in the oversight and management of royalty agreements involving copyrighted material. These primarily consist of government agencies and nonprofit associations that monitor intellectual property rights and, in some cases, actually collect royalties due to member companies.
The primary government agencies that are involved in royalty situations are the U.S. Copyright Office and the U.S. Patent and Trademark Office. Neither agency is directly involved in royalty payments, but both play an important role in the process. The Copyright Office provides all original authored works (including literary, dramatic, musical, and artistic works) with full protection under the law. When an author, artist, or publisher applies for a copyright, he or she receives the right to reproduce the work, to prepare derivative works based upon the work, to distribute copies of the work, to perform the work publicly, to display the work publicly, and, in the case of records, to perform the works by way of digital audio transmission. The length of time that a copyright lasts varies depending on the work and when it was published, but it is a minimum of several decades in every case. This means that only the person or company that holds the copyright for a work can license that work and receive royalties for it.
The Copyright Office determines when royalties are required, and its latest target is the Internet. Just as it requires cable and satellite television systems to pay licensing fees for content, the office is close to requiring Internet "Webcasters" to pay royalties as well for broadcasting the copyrighted work of artists. Webcasters include online services that broadcast radio and television programming and movies over the World Wide Web.
Similarly, the Patent Office protects inventors and their inventions. Whenever a person or company invents a new product or process, he or she can apply for a patent to indicate that he or she did invent that product or process, which grants him or her full protection under the law. If the work submitted is found to already exist or to be too derivative of an existing patent, then the new patent is not granted. Like a copyright, a patent gives the holder of that patent the right to license the product or service under royalty agreements, in this case for 17 years.
In the private sector, one of the major royalty organizations is the American Society of Composers, Authors, and Publishers (ASCAP), an association that protects the rights of its members working in the music industry (primarily composers, songwriters, lyricists, and music publishers). ASCAP monitors all public venues where music is played and collects royalties for its members by negotiating licensing agreements and fees with those venues, mainly radio stations. In addition to radio, however, ASCAP also closely monitors network, local, and cable television; live concert venues; college radio stations; bars, clubs, and restaurants; and background music services such as MUZAK. Every single time a songwriter's song is played, ASCAP collects money for the songwriter. This greatly simplifies the process of collecting royalties for creative works, and other similar organizations exist for writers and other creative professionals.
Another example of an umbrella organization that gathers royalty payments for a large number of clients is the Copyright Clearance Center, Inc. (CCC). Created at the suggestion of Congress in 1978, the CCC is a central body for licensing, recording, and collecting royalty fees.
CCC describes its own scope on its Web site as follows: "Copyright Clearance Center manages the rights to over 1.75 million works and represents more than 9,600 publishers and hundreds of thousands of authors and other creators. The company's streamlined, convenient compliance solutions enable more than 10,000 corporations and subsidiaries, including most of the Fortune 100, and thousands of government agencies, law firms, document suppliers, libraries, academic institutions, copy shops and bookstores to respect the rights of copyright holders and lawfully reuse the copyright-protected information they need to drive their business." This service is not necessarily intended to capture royalties from the average person when they make a copy of an article at their local library; instead, the CCC is intended to ensure that large-scale copying is monitored so that publishers can be fairly compensated for their work.
More than 3,500 high-volume users are registered with the CCC as part of its Transactional Reporting Service so that their payments for copying materials can be easily processed (the alternative would be to contact each publisher individually and negotiate separate royalty agreements with each).
A CHANGING ENVIRONMENT
Royalties have long compensated authors, artists, composers, and other creative producers as copyrights have protected their creations from piracy. The Internet has introduced a formidable new factor into the old equation both by making the electronic duplication of works easy and rendering such works readily searchable using programmatic means. As reported by Kevin Kelly in The New York Times Magazine, massive ventures are underway to digitize the world's books in efforts led by Google but also carried out by Amazon.com, by Superstar (in China, on Chinese books), and others. Major libraries, e.g., the New York Public Library, and universities are participating. Kelly, peering into the future, foresees a weakening of the old model based on copyright and royalties as the Internet appears irresistibly to swallow all information. Depending on how copyright issues are eventually resolved, royalties, at least in relation to intangible products of the human mind, may give place to other forms of compensation. Ad revenues, anyone?
"Creating Copyright Solutions." Copyright.com. Available from http://www.copyright.com/ccc/do/viewPage?pageCode=au1. Retrieved on 25 May 2006.
Harrower, Andy. "Copyright Issues in Internet Music." Contemporary Music Review. December 2005.
Kelly, Kevin. "Scan This Book!" The New York Times Magazine. 14 May 2006.
Stoddard, Steven A. "Maximizing Federal Natural Gas Royalties." Interfaces. September-October 2005.
U.S. Copyright Office. "Notice of Inquiry Concerning Orphan Works." 26 January 2005.