A Beginner’s Guide to Understanding Royalties

Learn about the different types of royalties, how they work, and how to sell your idea, invention, or product and claim your share of a $100 billion royalty market.

On ABC’s Shark Tank, you’ll often hear investor Kevin O’Leary ask for a royalty deal rather than equity in the company. He’ll invest in a company and get a piece of the action for every product sold. With royalties, even if a company he invests in loses money, he’s still making money when products are selling online or in stores.

This is called royalty financing. Companies give up royalties on product sales to attract investors.

It’s one way to look at royalties, but not the most common way. More typically, someone owns the rights to something and wants to license it to someone else as part of their sales strategy.

It’s big business. There are even marketplaces for the sales and marketing of royalties. Royalty Exchange, an online royalty broker, estimates that more than $100 billion in royalty payments are paid each year.

Overview: What are royalties?

Royalties are the fees someone pays to another party for licensing to use or sell their products. Typically, royalties are paid as a percentage of revenue that’s generated by the product.

Royalties are common when someone invents a product and sells it to another party in exchange for a payment. For entrepreneurs and businesses, the royalties business can be a great way to generate passive income.

4 types of royalties

Royalties can apply to physical products, technology, intellectual property, and resources.

Product royalties

Whenever a computer manufacturer sells a PC with the Windows operating system preloaded on it, they pay a royalty fee to Microsoft. That’s an example of a product royalty. In this case, Microsoft has licensed the royalty product rights to install and use its software in exchange for a percentage of future sales.

Resource rights

Royalties can also extend to tangible assets. For example, the owner of an oil well might enter an agreement with another company to extract and market the oil for a percentage of the selling price. Companies might give royalties to landowners in exchange for the mineral rights beneath the property.

It can be a lucrative venture for property owners. The U.S. government collects billions in mineral rights annually.

Intellectual property

Intellectual property can take several forms from patents to brands to artistic copyrights.

• Patents: The owner of a patented process or technology will license its use to other companies.
• Brands: A brand owner might license their name or trademark in exchange for royalty fees. For example, Calvin Klein or Ralph Lauren might grant rights to develop product extensions using their name. A university might allow someone to put their trademarked logo on a product in exchange for a licensing fee or a percentage of sales.
• Artistic: Songwriters and music copyright holders get royalty payments from radio stations or anyone else performing their music. Authors often get paid an advance against future royalties. Royalty income might come from the use of copyrighted artwork or images.

Franchise rights

Another common form of royalties involved franchise rights. If you wanted to open up a McDonald’s restaurant, you’d pay the company 4% of gross sales in perpetuity for the rights. These rights vary depending on the company. Subway franchisees pay weekly royalties of 8%, for example.

How do royalties work?

Royalties are a way to generate income by allowing someone else to use or sell your products without giving up ownership in most cases. You’re granting permission to use or produce something while retaining the rights yourself.

A licensing agreement governs the terms and establishes the amount of royalties. It might be a per-unit payment for goods or calculated as a percentage of sales. For intangible assets such as music, rates might be negotiated by industry groups on behalf of artists.

FAQs

• What should a licensing agreement include?

  A licensing agreement will govern the terms under which products can be used and the royalty amounts paid for the rights. It should include:

  • Exclusivity: Whether the rights are exclusive or shared
  • Ownership: Who retains ownership and whether rights can be transferred or resold
  • Limitations: How products can be used, including markets and territories (geographical limitations)
  • Duration: How long rights will continue
  • Termination: Circumstance upon which rights can be terminated
  • Payments: How payments are structured, such as if payments are made in advance or concurrently with sales
• What is a reasonable rate for royalties?

  Royalty rates vary greatly by industry and type. Here are some of the average rates by industry.

  Highest Average Royalty Rates

  • 9.6% software
  • 8% energy and environment
  • 6.4% health care equipment or products
  • 6.4% industrial goods

  Lowest Average Royalty Rates

  • 4.3% chemicals
  • 4% aerospace
  • 3.3% automotive
• What impacts the market value of a royalty?

  There are several factors that determine the market value, including scarcity and uniqueness. It also depends on the size of the market, the level of exclusivity in the licensing agreement, and competitive forces.

  Ultimately, it’s determined by your value proposition in relation to other products on the market. A company isn’t going to pay royalties to use a product if they can create a similar product or purchase one cheaper elsewhere.

• How are royalties taxed?

  According to the IRS, royalties from patents or copyrights are considered ordinary income for individuals. If you get royalties for the use of your property, this would be classified as business income or self-employment income if you’re not operating as a business.

  Royalties taxation would be considered business income for companies.

  If you are paying royalties to others, these would be classified as business expenses rather than income. If a royalty payment comes from mineral properties, several special rules apply.

  There are exceptions and nuances to all these rules, so if you have questions about royalties and taxes, make sure you consult a professional tax advisor.

• How can I sell an idea to a company?

  If you’re trying to figure out how to sell an idea and get royalties, you’re not alone. You can do directly to companies with a formal presentation but be aware many companies do not accept unsolicited proposals to avoid legal problems. You’ll likely have to submit ideas and provide significant documentation before you get a chance to do any personal selling.

  One of the first things companies will want to know if you own the clear rights to an idea or product. This will require work on your part before approaching a third-party.

  For example, if it’s a product or technology, they’ll want to know if you have a patent or whether it’s even eligible for a patent with infringing on other patents. If it’s a piece of music, artwork, or manuscript, they’ll want to know that you have clear ownership and copyrights for the work in question.

  There are also brokers and agents that will act as intermediaries in pitching an idea as part of the sales process. However, they’ll want a commission on the sale or require royalty fees for brokering a deal.

Royalties can be a profitable -- and beneficial -- business

Royalties can be profitable for both parties. For those granting the rights, it allows them to earn passive income and benefit from their invention, property, or ownership. For those acquiring the rights, it can help them enhance their products. It may also help them get products to market more quickly by using existing elements rather than creating their own.