Understanding Royalty Agreements for Products and IP

Key Takeaways

• A royalty agreement allows licensors to receive compensation for the use of their product, content, or intellectual property.
• Key components include royalty rates, payment schedules, scope of rights, and dispute resolution.
• Royalty types vary: fixed, percentage-based, lump sum, or hybrid.
• Territorial restrictions, duration, exclusivity, and sublicensing rights are crucial negotiation points.
• Thorough due diligence and legal review are essential before entering a royalty agreement.

A product royalty agreement helps both inventors and producers of products. This is a type of agreement that an inventor or creator of a product will utilize when he or she is not capable or not willing to take on the task of manufacturing a product for sale. The inventor can enter into an agreement with a manufacturer to produce the product for a portion of the sales. This is a very beneficial option for many different parties.

What is a Product Royalty Agreement?

Also commonly known as a licensing agreement, a product royalty agreement is a document that is arranged between inventors and manufacturers. It provides the right of a manufacturer to create, produce, market, and sell a product for a certain period of time while paying a royalty to the inventor.

This arrangement is typically used when a producer, author, creator, or inventor licenses their content, product, or invention to other companies for production.

Creating a product is different than actually having the capability to take the product and produce it for sale. This is the reason many inventors turn to licensing agreements.

Before making an agreement with a licensor, certain preparations need to be considered. When you are the owner to the rights of any product, there is not always an automatic way to make any money from it without its manufacture and sale. You can do that yourself; the easiest route to this outcome is to license it to another organization that will complete that task on your behalf for a portion of the revenue.

When to Use a Royalty Agreement

A royalty agreement is often used when:

• The inventor or IP owner lacks the resources or infrastructure to manufacture, distribute, or market the product.
• A business wants to expand into new markets without creating new IP.
• A company seeks to monetize dormant intellectual property or patents.
• Franchises and licensors want to generate recurring revenue from brand usage.
• Two parties want to formalize a licensing relationship with legal protections and revenue expectations.

This makes royalty agreements a flexible tool for both monetization and strategic partnerships.

Common Types of Royalty Agreements

Royalty agreements can take several forms depending on the nature of the product, service, or intellectual property being licensed. The most common types include:

• Product Royalties: These involve physical goods or manufactured products, typically negotiated as a percentage of net sales.
• Copyright Royalties: Used in industries like publishing or music, these apply to creative works licensed for reproduction or distribution.
• Patent Royalties: Common in technology and pharmaceuticals, these cover the licensed use of patented inventions.
• Trademark Royalties: Typically used in franchising or branding arrangements, allowing a licensee to use a recognizable brand.
• Hybrid Royalties: Combine features of two or more types, such as a patent license that includes trademark usage for brand continuity.

Each type of royalty agreement may include different terms and calculation methods, making it important to tailor the contract to the specific context.

Terms and Conditions of a Product Royalty Agreement

Your contract will outline all terms of your arrangement. It will include the following:

• The name of the licensee as the manufacturer and the licensor as the inventor. This will include a short description of the invention, the patent number, in which territory it may be sold, the length of the arrangement, the royalty percentage, and the schedule of payments.
• The grantor will grant the rights to the product to the grantee for use for a specified amount of time.
• The grantor will establish that he or she owns the invention listed in the contract and will hold all the rights to enter a royalty agreement.
• When signing the agreement, the grantor will agree to provide delivery of any necessary documentation for the property to the grantee for the term that is agreed upon.
• If there is a breach, the grantor will agree to not hold the grantee responsible for damages, losses, or injuries as a result.
• During the term of the agreement, the grantee agrees that all property that is included will maintain confidential.
• Should there be a threat to the confidentiality of the property, the grantee will provide notice to the grantor and come to a conclusion regarding the breach.
• If there is negligence on the part of the grantee that causes loss, injury, or damage, the grantee will hold the grantor without harm and work to seek a remedy.
• The agreement will also list the royalty rates and how often they are to be paid.

There is not going to be a set royalty rate that will apply to all forms of products, but the 25 percent rule is used most commonly. This rule provides that you can typically receive around 25 percent of the profits made when your product is sold. If the profits increase, so does your income.

Another rule used is the 5 percent of net rule. This means you can make up to 5 percent of the selling price after cost. The costs include manufacturing costs, advertising, delivery, and administrative costs. This can result in a smaller royalty than if you had only estimated deducting the cost of materials.

The royalty percentage will be a combination of the percentage of royalty, the raw cost of the product, the amount of the product sold, and the timeframe of the contract. A smart licensor will consider all of this at the beginning of searching for products to manufacture before making a huge investment into a product to sell.

Best Practices for Negotiating a Royalty Agreement

Effective negotiation helps align both parties’ expectations. Consider these best practices:

• Conduct Due Diligence: Verify the market potential, IP ownership, and financial reliability of the other party.
• Define Clear Metrics: Avoid ambiguity in performance expectations and reporting requirements.
• Protect Confidential Information: Use confidentiality clauses and NDAs to protect trade secrets and sensitive data.
• Plan for Dispute Resolution: Include mediation, arbitration, or jurisdiction clauses to handle disagreements efficiently.
• Consult Legal Counsel: Engage an attorney with licensing experience to review the terms, especially around IP rights and liability.

For help drafting or reviewing a royalty agreement, you can connect with experienced attorneys on UpCounsel’s marketplace.

Licensing vs. Assignment of Rights

In a royalty agreement, the licensor typically retains ownership of the intellectual property and grants limited rights for use. This differs from an assignment of rights, where ownership is fully transferred to another party.

Licensing is preferred when the original creator wants to maintain long-term control or benefit from recurring income.

Common Royalty Structures and Payment Models

Royalties can be structured in various ways depending on industry norms and negotiation terms:

• Percentage of Sales: The most common method; royalties are a fixed percentage of gross or net sales.
• Fixed Fee Per Unit: A set dollar amount for each unit sold.
• Minimum Guarantee: A base royalty payment regardless of sales, offering security to licensors.
• Advance Against Royalties: An upfront payment deducted from future royalties, offering early compensation to the licensor.
• Sliding Scale or Tiered Royalties: Royalties increase or decrease based on performance milestones (e.g., more sales = lower rate).
• Lump Sum: One-time fee for full rights within a specified term or region.

Choosing the right structure requires assessing the market potential, risks, and the bargaining power of both parties.

Key Clauses to Include in a Royalty Agreement

To ensure clarity and avoid disputes, the following clauses should be carefully drafted:

• Grant of Rights: Define the exact rights granted (e.g., manufacture, distribute, sublicense) and limitations (e.g., territory, exclusivity).
• Royalty Structure: Detail how royalties are calculated—percentage of net or gross revenue, per-unit fees, minimum guarantees, or tiered rates.
• Payment Schedule: Specify how frequently payments are due—monthly, quarterly, annually—and the required reports or audits.
• Duration and Termination: Clarify the agreement's length and under what conditions it can be renewed or terminated.
• Performance Milestones: Include benchmarks (e.g., product launch by a set date, minimum annual sales) that help gauge compliance.
• Intellectual Property Ownership: Reinforce that the licensor retains ownership of the IP, even while it's being used under license.
• Audit Rights: Allow licensors to audit the licensee’s books to verify royalty calculations.
• Indemnification and Liability: Define responsibilities in the event of IP infringement claims or third-party disputes.

Frequently Asked Questions

1. What is a royalty agreement used for?
   A royalty agreement allows one party to use another's product, intellectual property, or creative work in exchange for compensation.
2. How are royalties typically calculated?
   They can be based on net or gross sales, per unit sold, or structured with minimum guarantees or tiered rates.
3. Can a royalty agreement be exclusive?
   Yes, an agreement can grant exclusive rights, meaning only the licensee can use the licensed property within the agreed territory or field.
4. What’s the difference between licensing and assigning rights?
   Licensing allows use without transferring ownership, while an assignment transfers full ownership permanently.
5. What should I do before signing a royalty agreement?
   Conduct due diligence, clarify all terms, and consult a legal professional to ensure your rights are protected.

If you need help with understanding product royalty agreements, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.