As a patent attorney dealing with licensing IP, when I review the licensing agreement, one of the most important section to pay attention to is the payment section, which typically specifies the licensing fee or royalties. The creators and owners are paid royalties to ensure they get the right compensation. Many royalties deal with payments for the right to use intellectual property (IP), such as copyright, patents and trademarks. If you want to learn more about how royalties are determined, read on!
Table of Content
What are Royalties?
How royalties work
Types of royalties
How do royalty payments work?
How are Royalties Calculated?
How are royalties taxed?
What are Royalties?
Royalties are a mode of payment that allows you to use another person’s property. Royalties are earned through licensing. It is the act of granting or getting permission for someone else’s creations or property.
Licensing is when you retain the ownership of the property and receive royalties from another for the use of that property. Licensing your company’s intellectual property and receiving royalties is a common way for you to increase your business’s income.
Although royalties can be found in many industries, they all serve the same purpose. These royalties can be granted through an agreement. They allow others to use the property and give the owner an income. Royalties also protect the buyer from claims of the owner for improper use.
In the IP world, patent royalties are payments made by a company or individual that uses a patented invention or product. The patent holder, or the person or company that holds the rights to the invention, is entitled to receive these royalties. The amount of the royalties is typically negotiated between the patent holder and the user, and can be a one-time payment or ongoing payments. Royalties can also be based on a percentage of the revenue generated by the use of the patented invention or product. The royalty rate is usually negotiated when the license agreement is signed. Similar arrangements are made for trademark and copyright licensing.
Examples of royalties
Music owners who own copyrighted music are entitled to royalties. These are known as performance royalty. This royalty can be paid if you wish to use a song in your movie or on your radio station.
Images may attract royalties if they are used on a website. A book royalty is another type of royalty that publishers pay authors for each book they sell.
A royalty will be paid to the owner of the patent if someone wishes to use or make a patented product.
Franchise royalties are paid to the main company by franchise holders for the use and promotion of the name and other assets.
In the case of rights to extract minerals from another person’s property, royalties are also be paid. They are sometimes called mineral rights and not royalties. However, they function in the same way.
How royalties work
There are many ways to set royalty fees or payment amounts. In a franchise, fees could be fixed or a variable percentage of gross sales. Royalties for oil, natural gas, and mineral properties can be based either on revenue or units such as barrels or tons of oil. IP-based royalties are typically determined through negotiation between the patent holder and the user. The process of determining the royalty rate can be complex and involves several factors such as the value of the invention, the potential market size, the stage of development of the product, and the economic life of the patent.
Some common methods used to determine a patent royalty include:
- Cost Plus: This method adds a markup to the cost of producing the patented product or technology to arrive at a royalty rate.
- Market-based: This method uses the market price of similar products or technologies to determine a royalty rate.
- Profit-based: This method uses the profit generated by the use of the patented product or technology to determine a royalty rate.
- Multiples of gross margin, EBITDA or net income: royalties are determined by applying a multiple to the gross margin, EBITDA or net income generated by the use of the patented product or technology
The final royalty rate is usually a combination of these methods and is determined by considering several factors such as the value of the invention, the potential market size, the stage of development of the product, and the economic life of the patent.
It is also worth noting that a patent holder may also license a patent for exclusive use or non-exclusive use, and the terms of such license can also affect the royalty rate.
For newly-created IP, a variable percentage is used. This is because sales are very low at the beginning, so the royalty percentage may be lower. As sales rise, the royalty percentage may increase to a maximum.
Some royalties are paid for public licenses. The Copyright Office collects royalties from:
- Retransmitting radio and TV broadcasts by cable operators
- Satellite carriers transmit network and non-network signals to satellites
- Distributors or importers of digital audio recording products
The Copyright Office Licensing Section collects royalty fee payments and maintains public records filed by cable operators for retransmitting television and radio broadcasts (section 111), from satellite carriers for retransmitting nonnetwork and network television broadcasts (section 119), and importers or manufacturers that distribute digital audio recording technology products (DART) (section 1003). In general, the section deducts its operating costs from royalty fees collected and invests the balance in interest-bearing securities with the U. S. Treasury for later distribution to copyright owners. The section also collects filing fees to cover part of the costs in administering the cable and satellite licenses.
Cable/Satellite Operators are required to pay Filing Fees, per filing, for each accounting period. Effective January 1, 2014, pursuant to the Satellite Television Extension and Localism Act of 2010 (STELA), which granted authority to the Copyright Office to establish fees for the filing of statements of account (SOAs) under the section 111, 119, and 122 statutory licenses, the Office now assesses filing fees for all SOAs for current, past, and future accounting periods. For details, see the Federal Register, November 29, 2013 (78 fr 71498). Please be advised that the filing fee is deducted before the royalty payment is credited; thus the omission of the appropriate filing fee will result in an underpayment of royalty fees. Please remit the royalty fee and filing fee in one EFT payment. (SOA1 filing fee: $15; SOA2 filing fee: $20; SOA 3 and Satellite SOA: $725.00). Current Licensing Section fees are specified at the Copyright Office website.
typical royalties for IP licenses
The range of royalties for IP (intellectual property) licensing can vary widely depending on several factors such as the type of IP, the industry, the stage of development of the product, and the potential market size.
For example, in the software industry, a typical royalty rate for a copyrighted software program is around 5-15% of the retail price, but it can go up to 30% for high-demand software. In the pharmaceutical industry, typical royalty rates for a drug under patent protection can range from the low single digits to the high teens as a percentage of net sales.
In the technology industry, the royalty rate can range from 1% to 15% of the net sales of the product or service that utilizes the licensed IP.
In the case of patents related to semiconductors or electronics, the royalties are often based on the selling price of the end product that incorporates the patented technology, and can range from 1% to 5% of the selling price.
It’s worth noting that the royalty rate can also be affected by whether the license is exclusive or non-exclusive, and the terms of such license can also affect the royalty rate.
Overall, the typical royalty rate can vary widely and it is important to consider the specific details of the IP, the industry, and the market conditions when determining a reasonable range for royalty. It is advisable to seek the advice of a legal professional or IP expert to help in determining a reasonable royalty rate for a licensing agreement.
Each royalty payment has its benefits and drawbacks. As you make a contract, as the owner of the property, you will discuss the details of royalty payments with potential buyers.
When negotiating a patent royalty contract, there are several key considerations that should be taken into account by both the patent holder and the user. These include:
- Royalty Rate: The percentage of revenue or sales that will be paid as royalties should be clearly defined in the contract.
- Term of the Agreement: The length of time the agreement will be in effect should be specified in the contract.
- Field of Use: The specific products, services, or markets in which the patented technology can be used should be defined in the contract.
- Exclusive or Non-Exclusive Licensing: The contract should specify whether the license is exclusive or non-exclusive. An exclusive license prevents the patent holder from licensing the technology to other parties, while a non-exclusive license allows them to do so.
- Minimum Royalties: The contract should specify the minimum royalties that must be paid, even if the user does not generate any revenue from the use of the patented technology.
- Audit rights: The contract should specify the rights of the patent holder to audit the user’s financial records to ensure that the correct royalties are being paid.
- Infringement indemnification: The contract should specify that the user will indemnify the patent holder against any claims of infringement of third-party rights
- Termination rights: The contract should specify the conditions under which either party can terminate the agreement.
- Dispute Resolution: The contract should specify the process that will be used to resolve disputes that may arise between the parties.
- Governing Law: The contract should specify the governing law and jurisdiction that will be used in case of disputes or legal action.
These are just some of the key considerations that should be taken into account when negotiating a patent royalty contract. It is important to seek the advice of a legal professional before finalizing any agreement.
Although royalty contracts can be different depending on the type, there are certain common elements to all royalty contracts.
A contract will contain a description of the subject matter (the properties) and its owner. If you sell the right to use a set of images to Getty Images, for example, you will describe the images in detail.
The contract will outline the limits and scope of the property’s use. You might permit someone to use your images for a single time or allow them to use them forever.
The contract will also include the payments (the royalties). This section should cover payments, including when they are due, how they are calculated, and how records will be kept. Sometimes, advance payment is made.
A “earn-out arrangement” could be included in the contract that bases royalties on the performance of the property being licensed. An advance is often included in an author’s contract. The author will receive additional royalties payments if the author’s share of royalties from book sales exceeds the advance.
How do royalty payments work?
The royalty payments are made through a legal agreement. They are paid on a regular basis by licensees to the owners of intellectual property and assets that have been granted a license to use them for the duration of the license period. Many times, royalty payments are calculated as a percentage of a net or gross revenues.
What’s a Royalty Deal?
A royalty deal is where an investor provides funds to a company, not the individual, in exchange for a percentage of total sales. Let’s take, for example, a beer company where an investor invests and gets 5% of the gross sales. The investor will earn $2.50 for every $50 beer that is sold.
How are Royalties Calculated?
Royalties for established brands are usually higher than those for new independent brands. A new product or service that has a high engagement rate might command a higher overall price. When calculating royalty payments, it is helpful to know how the market views your assets and property.
Because royalties are calculated on a percentage basis, it is relatively simple to calculate them.
- Step 1. Find your annual sales and share them with the party who pays you royalties
- Step 2. Multiply this amount by your contractual royalty rate
- Step 3. The final output shows how much royalties you are owed.
Royalty payments can be calculated manually according to each product. You can also automate your tracking by sending data to a system that will validate your calculations against the contract terms.
How are royalties taxed?
All royalties are taxable as ordinary income. The Internal Revenue Service (IRS), therefore, requires that you report them in Part 1 of Schedule E on Forms 1040-SR or 1040-SR. They tax royalty income differently from other forms of income sources and depend on a variety of factors.
Some of these varying factors that play a role in royalty payment taxation include:
- Profitability at work
- Reported revenues
- Ownership of assets
There is no universal formula for taxing royalty income. However, royalties from your work are usually reported as self-employment income. These are reported on Schedule C of the IRS form 1040.
You must declare any self-employment income exceeding $400, including royalties. Schedule E on the IRS Form 1040 can be used to report royalty income from one-time earnings or mineral interests.