Royalty definition
/What is a Royalty?
A royalty is compensation paid in exchange for the use of intellectual property or natural resources. The royalty is typically computed as a percentage of the sales or profit proceeds generated from the use of these assets. The terms of the arrangement are contained within a license agreement, which is entered into by the asset owner and the party wanting to use the asset. The license agreement sets the royalty rate and limits the extent to which the asset can be used.
Characteristics of a Royalty
The key characteristics of a royalty are as follows:
Payment for use of an asset. Royalties are payments made for the right to use intellectual property (e.g., patents, copyrights, trademarks), natural resources, or business methods.
Based on usage or revenue. Royalty payments are often calculated as a percentage of the revenue generated by the use of the asset (e.g., sales of a book or software).
Recurring payments. Royalties are typically paid periodically (e.g., monthly, quarterly, or annually) as long as the asset or resource is being used. Payments cease when the licensing agreement ends or the usage rights expire.
Governed by licensing agreement. The terms of royalties, including the rate, duration, scope of usage, and payment schedule, are specified in a legally binding licensing agreement.
Exclusive or non-exclusive rights. Royalties may be tied to either exclusive or non-exclusive rights.
Upfront fees or advances. Licensing agreements may include an upfront payment or advance on royalties, particularly in publishing, entertainment, or franchise agreements.
Minimum payment clause. Some royalty agreements include minimum guaranteed payments, ensuring the licensor receives a baseline amount regardless of usage or revenue generated.
Audit and reporting requirements. Licensees are often required to maintain detailed records of sales, usage, or revenue and provide periodic reports to licensors. Licensors may have the right to audit these records to verify royalty calculations.
Examples of Royalties
Several examples of royalty situations are as follows:
A cell phone manufacturer pays a royalty to the holder of a patent relating to the technology within the phone.
A franchisee pays a royalty to a franchisor in exchange for the use of the franchisor’s business model, processes, and trademarks.
A publisher pays a royalty to an author in exchange for the right to print and distribute the author's books.
An oil & gas firm pays a royalty to a landowner in exchange for the right to drill on his land.