Royalty sales are ongoing payments that are made to an owner of an asset or property when it is used. Royalty sales can be assigned for such things as:

  • Patents
  • Franchises
  • Copyrighted work
  • Property

Royalties were created to provide compensation for an owner's assets use, and these agreements are legally binding. A royalty will be based on your net sales instead of profits to make sure the asset owner is compensated for the use.

Royalty Breakdown

Royalties are most often determined as a percentage of either the net or gross revenue the company has received for the use of the owner's property. The particulars can be negotiated at the time the agreement is made. Using royalties is a common practice where an owner or inventor decides to sell their product or idea to a third party in exchange for a portion of the future revenues the product will generate.

An example of a royalty agreement would be companies that produce computers and pay a royalty to Microsoft in order to use the Windows operating system.

There are a wide variety of royalties that can be offered, including:

  • Trademark royalties
  • Patent royalties
  • Franchise
  • Copyrighted materials
  • Nonrenewable resource royalties
  • Art royalties
  • Music royalties
  • Book publishing royalties

License Agreement

Royalties are paid under the terms outlined in a licensing agreement. These agreements will define all the restrictions and limitations of the royalties, such as:

  • Geographic territory
  • The length of the agreement
  • The types of products will pay royalty cuts

A license agreement will be regulated differently if it is a private agreement or a government agreement. Additionally, the rate of royalty that is charged for each service or product will depend on the type of royalty fee that is listed in the agreement.

There are many factors that may affect the rate of royalty. Some of the factors that can affect the royalty rate include:

  • Exclusivity rights
  • Risk involved
  • Alternatives that are available
  • Market demand structure
  • Sustainability of involved technologies
  • Level on innovation

To provide an accurate estimate of the royalty rates, certain requirements must be met.

  • There must be transacting parties, including a buyer and seller.
  • The transaction cannot occur by means of force.
  • The transaction must be at arm's length, which means the parties can have no relationship with each other.

Sales vs. Profits

Net sales are funds a company takes in from the sale of the product or service, minus such figures as discounts for volume or discounted merchandise that has been damaged. Profit is the money that remains after a company has subtracted the cost to make and utilize a product from the amount they sold it for.

Understanding Your Net Sales

The most common measurement to determine royalty payments is through the use of net sales. Many people insist royalties be paid from net profits, as royalties are considered to be part of the cost of production of a product. Additionally, it provides more assurance that they will receive their percentage even if the company does not make a high profit on the product or service.

Once a percentage is determined, it will be multiplied by the total net sales to find out the amount to be paid. Since royalties are most often based on net profit, it is essential to clearly define net sales and what deductions should be included when determining the amount.

Examples of deductions that can be subtracted when determining net sales include:

  • Shipping costs
  • Credits
  • Taxes
  • Returns
  • Sales discounts

Some less common items that can be included in net sales deductions are:

  • Sales commissions
  • Debts
  • Uncollectable accounts
  • Marketing
  • Promotions
  • Advertising

Quantity Discount Deduction

There are times when licensees may try to increase sales by providing a discount to customers who want to buy the product in larger quantities. These discounts are often referred to as volume discounts. This is commonly used to increase sales. To protect yourself against unscrupulous licensees, you will want to include language in the agreement that defines how the discount will qualify. You need to make sure the discount is applied before the items are shipped so it will not diminish the royalty payment you are entitled to.

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