What Is a Royalty?

A royalty is a legally-binding payment made to an individual, for the ongoing use of his or her originally-created assets, including copyrighted works, franchises, and natural resources. But royalties are predominantly associated with musicians, who receive such payments whenever their originally-recorded songs are played on the radio or television, used in movies, performed at concerts, bars, and restaurants, or consumed via streaming services. In most cases, royalties are revenue generators specifically designed to compensate the owners of songs or properties, when they license out their assets for another party's use.

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Royalty

Royalties Explained

Royalties payments typically constitute a percentage of the gross or net revenues obtained from using the owner's property, however, they can be negotiated on a case-by-case basis, in accordance with the wishes of both parties involved in the transaction.

The use of royalties is common in situations where an inventor or original owner chooses to sell his product to a third party, in exchange for royalties from the future revenues the product may generate. For example, computer manufacturers pay Microsoft Corporation royalties for the right to use its Windows operating system in the computers they manufacture.

Payment may be nonrenewable resource royalties, patent royalties, trademark royalties, franchises, copyrighted materials, book publishing royalties, music royalties, and art royalties. Well-known fashion designers can charge royalties for the use of their names and designs, by other companies.

Third parties pay authors, musical artists, and production professionals for the use of their produced, copyrighted material. Television satellite companies provide royalty payments to air the most viewed stations nationwide. In the oil and gas sectors, companies provide royalties to landowners for the permission to extract natural resources from the landowners' covered property.

[Important: Royalty agreements should benefit both the licensor (the person receiving the royalty) and the licensee (the person paying the royalty); for the licensor, a royalty agreement to allow another company to use its product can allow them access to a new market, while for the licensee, an agreement may give them access to products they could not access otherwise.]

Special Considerations

License Agreements

The terms of royalty payments are laid out in a license agreement. The license agreement defines the limits and restrictions of the royalties, such as its geographic limitations, the duration of the agreement, and the type of products with particular royalty cuts. License agreements are uniquely regulated if the resource owner is the government or if the license agreement is a private contract.

Royalty Rates

In most license agreements, royalty rates are defined as a percentage of sales or a payment per unit. The many factors that can affect royalty rates include exclusivity of rights, available alternatives, risks involved, market demand, and innovation levels of the products in question.

To accurately estimate royalty rates, the transactions between the buying and selling parties must be willingly executed. In other words: the agreements must not be forced. Furthermore, all royalty transactions must be conducted at arm's length, meaning that both parties act independently, and have no prior relationship with one other.

Key Takeaways

  • A royalty is an amount paid by a third party to an owner of a product or patent for the use of that product or patent.
  • The terms of royalty payments are laid out in a license agreement.
  • The royalty rate or the amount of the royalty is typically a percentage based on factors such as exclusivity of rights, technology, and the available alternatives.

[Fast Fact: According to Upcounsel.com, a nationwide legal services company, the industries with the highest average royalty rates are software (9.6%), energy and environment (8%), health care equipment and products (6.4%), and industrial goods, while the industries with the lowest average royalty rates are automotive (3.3%), aerospace (4%), and chemicals (4.3%).]