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What Are Royalties: Definition & How Do They Work?

Updated: November 23, 2022

Royalties can be used by business owners to generate income flow from their original ideas. To access and use ideas which other people have generated for the purpose of promoting their business, a firm may pay royalties.

You should understand what royalties are if you create intellectual property or are working for a business that does in order to be able to make informed judgments.

Read on as we take you through exactly what royalties are, how they work, and how they are calculated.

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    KEY TAKEAWAYS

    • A royalty is a specific amount that gets paid to the owners of an asset by a third party. The owner is paid due to their asset being used by the third party. 
    • Royalty payment terms are outlined in a licensing agreement that gets developed between the owner and the third party.
    • In most cases, royalty agreements are going to benefit the person receiving the royalty and the person paying it. These are also known as the licensor and the licensee. 
    • The amount of royalty that gets paid is usually a percentage. It’s based on various factors that can include the exclusivity of rights, certain technology, or any available alternatives.

    What Is a Royalty? 

    A royalty is a type of payment that’s legally binding and it’s usually made to a company or an individual for the use of their assets. This usually happens on an ongoing basis and assets can include things like natural resources, franchises, and copyrighted works. 

    One of the best examples of a royalty fee is the payments that a musician would receive from their music being played on television or radio. They might also receive royalties if their music is performed at concerts, used in movies, or consumed through a streaming service.

    Most of the time, royalties are an excellent type of revenue generator. They’re designed to help compensate the original owner of an asset when another party uses them.

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    How Royalties Work

    In a simple sense, royalties are going to equate to a specific percentage of any revenues that are generated from the use of property. That said, royalties are often negotiated on a case-by-case basis to ensure that all parties involved in the transaction receive fair returns. 

    For example, someone who invents a product can choose to sell it to a third party. In the licensing agreement, they might specify that the sale is in return for royalties generated from future revenues that the product earns. 

    Another example would be a computer manufacturing company obtaining the rights to use an operating system, such as Windows. If this was the case, they would pay Microsoft Corporation a royalty percentage to use the operating system in the computers that they manufacture. 

    Payment of royalties can come in a few different forms, as well. These can include:

    • Patent royalties 
    • Nonrenewable resource royalties 
    • Copyrighted materials 
    • Book publishing royalties 
    • Franchises 
    • Music royalties 
    • Art royalties 
    • Use-of-name royalties 

    In many cases, a third party would pay the likes of musical artists or authors royalties for the use of their copyrighted material. As well, a television satellite company would pay royalty payments to the stations that they air. 

    In the oil and gas sectors, companies would pay out royalties to landowners, for example, to extract certain natural resources from their property. 

    With all of that said, it’s important to note that royalty agreements should always benefit both the licensee and the licensor. When it comes to a licensee, the agreement could provide them access to certain products or services that they wouldn’t be able to obtain otherwise. 

    When it comes to a licensor, the royalty agreement would allow other companies or third parties to use their product or service, ultimately providing them access to a new market. 

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    Different Types of Royalties 

    There can be a wide range of royalty types depending on the needs of the licensee and the product or service the licensor can provide. 

    Here are some of the most common types of royalties to know and understand: 

    • Franchise Royalties: With a franchise, a business owner would pay out royalties to the franchisor to be able to open a business with the same name. For example, McDonald’s is a common type of franchise, where franchise owners would pay royalties back to the McDonald’s Corporation.
    • Patent Royalties: When a creator, innovator, or inventor creates a new product, they will typically patent it. After this, a company or third party can pay royalties to be able to use the product but will need to agree to a licensing agreement. By doing this, a patent owner can ensure they’re compensated for the intellectual property they created. 
    • Book Royalties: With book sales, publishers would pay royalties to the book author. This often happens for every book that gets sold. The author would then receive the agreed amount outlined in the licensing agreement in return.
    • Music Royalties: If a radio broadcast, movie, or television show uses copyrighted music in their performances, they would pay a royalty to the owner of the original songs. For example, a musician will receive performance royalties payment each time that a radio station plays their song. 
    • Mineral Royalties: This can also get referred to as mineral rights, but mineral royalties are usually paid to land and property owners. When a third party wants to extract mineral properties or natural resources from the property, they would pay specified royalties back to the owner of the land or property. For example, a landowner might receive royalties for the barrels of oil that are generated from their types of property. 

    How Are Royalties Calculated? 

    Usually, royalty rates are going to be similar in most licensing agreements. They’re often defined as a payment per unit or as a percentage of sales. However, there can be several factors that affect the payment amounts and how they’re calculated. 

    Some of the factors can include any risks involved, the exclusivity of rights, any available alternatives, innovation levels, and the market demand for the product or services wanted. There can also be a variable percentage outlined when it comes to royalty income. 

    In the case of average royalty rates in music, for example, the license agreements might specify that there is a set amount that will get paid for every time a musician’s song is played on the radio. So, if over the course of the next 3 months the song is played a total of 150 times, the licensor would receive the set amount multiplied by the number of times the asset was used. 

    Whatever the case, the terms of royalty payments will be outlined in the licensing agreement. They can include things like royalty cuts, the portion of royalties, and the overall royalty structure.

    Summary

    Royalties are an excellent way to earn additional money from assets that are owned. The likes of innovators, inventors, creators, intellectual property owners, and landowners can all benefit from this. 

    Licensing agreements are a legal contract and they are going to be put into place to outline all the details and terms of the royalties. Within the agreement, it will specify that the licensee has the approval of the licensor to use their assets. This means that intellectual property rights are covered for any licensed product. 

    Different kinds of intellectual property can include everything from trademarks, patents, and copyrights. Plus, there are several different types of royalties to consider. They can be earned on franchises, books, music, minerals, and many more. 

    Different royalty agreements are going to have varying terms, however, royalties can be earned in perpetuity or over a set period of time.

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    FAQs About Royalties

    What Is a Royalty Check?

    A royalty check is the money that a licensor would receive in return for a third party using the product or service they created. For example, a software company would receive a royalty check for the amount due from a licensee that entered into a licensing agreement with them.

    Who Pays the Royalties?

    The person, or third party, that enters into the licensing agreement would pay royalties back to the creator, or licensor. This can sometimes be an individual or a company or a corporation.

    How Long Do Royalties Last For?

    How long royalties last depends on the licensing agreement that is made. Some can last for a predetermined time frame, such as 3-5 years. Other royalties can last for a lifetime.

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