What Are Royalties: Definition & How Do They Work?

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 right to use their assets or intellectual property. 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 receives 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 the asset.

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  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 give other companies or third parties a right to use their product or service, ultimately providing them access to a new market. 

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 royalties to the franchisor to be able to open a business under their 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 for their right  to use the product per 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. A royalty is paid to the author for every book that is sold.
• Music Royalties: If a radio, movie, or television show uses copyrighted music in their broadcasts, they pay a royalty to the owner of the original songs. For example, a musician will receive performance royalties  each time  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.  Innovators, inventors, creators, intellectual property owners, and landowners can benefit from a royalty income. 

Licensing agreements are a legal contract put into place to outline all the details and terms of the royalty payments and licensee’s rights to use the asset.

 Intellectual property can include everything from trademarks and patents to copyrights. Plus, there are several other types of royalties to consider. Royalty income 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. 

Written by Sandra Habiger

Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at https://www.sixfiguresaccounting.com/ .

Written by Sandra Habiger

Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at https://www.sixfiguresaccounting.com/ .