What Is a Royalty?

A royalty is a payment to an owner for the ongoing use of their asset or property, such as patents, copyrighted works, franchises, or natural resources. The legal owner of the property, patent, copyrighted work, or franchise receives a royalty payment from licensees or franchisees who wish to make use of it to generate revenue. In most cases, royalties are designed to compensate the owner for the asset's use, and they are legally binding.



Royalties Explained

Royalties are typically a percentage of the gross or net revenues obtained using the owner's property, but they can be negotiated to meet the specific needs of an arrangement. 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. Royalty interests are the legal rights to collect future streams of royalty payments.

For example, computer manufacturers pay Microsoft royalties for the use of the 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 industries, companies provide royalties to landowners for 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

The royalty rate or the amount of royalty charged per product or service depends on the type of royalty fee. Many factors affect the royalty rate. The most common factors include exclusivity of rights, the available alternatives, the risks involved, market demand structure, the technologies involved, and the level of innovation the product or service provides. 

To accurately estimate royalty rates, there must be willing transacting parties (buyer and seller), the transaction must not be forced, and the transaction must be at arm's length (the transacting parties act independently and have no relationship with each 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%).]