What Is a Royalty? How Payments Work and Types of Royalties (2024)

What Is a Royalty?

A royalty is a legally binding payment made to an individual or company for the ongoing use of their property, including copyrighted works, franchises, and natural resources. Royalties can be collected for tangible and intangible assets.

An example of royalties would be payments received by musicians when their original 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 property when they license their assets for another party's use.

Understanding Royalties

Royalty payments typically constitute a percentage of the gross or net revenues obtained from the use of property. However, they can be negotiated on a case-by-case basis according to the wishes of both parties.

Who Would Use a Royalty System?

An inventor or original owner may choose to sell their 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.

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

Payment and Benefits

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 to other companies for using their names and designs.

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. For the licensee, an agreement may give them access to products they could not access otherwise.

Types of Royalties

Royalty payments may cover many different types of property. Some of the more common types of royalties:

• Book royalties: Paid to authors by publishers. Typically, the author will receive an agreed amount for every book sold.
• Performance royalties: The owner of copyrighted music receives an amount whenever the music or song is played by a radio station, used in a movie, or otherwise used by a third party.
• Patent royalties: Innovators or creators patent their products. Third parties typically enter into a licensing agreement requiring them to pay royalties to the patent owner.8
• Franchise royalties: A franchisee, a business owner, will pay a royalty to the franchisor for the right to open a branch under the company name
• Mineral royalties: Mineral royalties are paid by mineral extractors to property owners.

Special Considerations

Licensing Agreements

The terms of royalty payments are laid out in a licensing agreement. The licensing 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. Licensing agreements are uniquely regulated if the resource owner is the government or if the license agreement is a private contract.

Royalty Rates

In many licensing agreements, royalty rates are defined as a percentage of sales or a payment per unit. Rates may also be a factor of:

• Innovation levels of the products
• The exclusivity of rights
• Available alternatives
• The business model
• The demand level
• Market demand
• Risks involved
• Gross margin
• Net margin

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.

Examples of Royalties

Book writers typically receive a share of the proceeds from the sales of their books. For instance, an agreement between a publisher and writer might be that the author receives 15% on net sales of hardbacks and 7.5% on net sales of paperbacks.

Franchises are another example where royalties are used. For instance, an individual can pay to open a restaurant franchise like McDonald's. A franchisee of the McDonald's Corporation has a typical initial down payment of 40% of the total for a new restaurant or 25% of the total for an existing one. Additionally, an initial franchise fee of $45,000 is paid to the McDonalds corporation.

After purchasing the franchise, the owner must then make ongoing royalty payments of 4%–5% of monthly sales and pay rent, which is either a base amount or a percentage of monthly gross sales.

The Bottom Line

Royalties are a way for creators, innovators, intellectual property owners, or landowners to earn money from their assets. Royalties are agreements or licenses that lay out the terms by which a third party can use assets that belong to someone else.

Royalties can be earned on books, music, minerals, franchises, and many other assets. Some royalty agreements are for a set period, while other royalties are earned in perpetuity.