How Royalties Work in Business

Royalty payments are a way for entrepreneurs, business owners and innovators to earn a percentage of the money generated by their brand when another business wants to use that brand under licence, such as selling the first business’ product or service. Alternatively, a company may license an idea from its owner.

Any business seeking to enter into a royalty agreement to either use another brand or incorporate someone’s licensed idea should understand the details and requirements for the licensee and the licensor.

How royalties work in business

Royalties in business work by one business using another entity’s intellectual property or patent to make a profit. The owner of the intellectual property then receives a percentage of that profit. 

This kind of royalty differs significantly from royalty financing, which is another common business royalty. Royalty financing involves a business owner paying an investor a royalty to receive immediate funding to raise capital quickly to grow their business. 

Franchise operators also pay a royalty to the franchise owners to use the branding, business model, products and services that made the original franchise successful.

Business royalty amounts are paid either as a percentage or as a flat rate, depending on the details of the royalty contract or licensing agreement that both parties sign. The licensing agreement will outline the royalty payment details and describe exactly what the intellectual property being licensed is. The deal will also dictate how and where the intellectual property can be used.

Royalty examples 

There are four main types of royalty:

• Intellectual property

• Products

• Resources

• Franchises

Intellectual property royalties

There are various royalties due to intellectual property rights, with the first being acquired through a patent. The owner of a patent can license the patented article for use by others or restrict it from being used in some instances. For example, the owners of a comics brand will patent the characters, and thus the characters cannot be used by other comic creators without licensing them.

Brands can also license their logos to other brands to use, while musicians copyright their music, so they receive a payment every time a radio station or public venue plays it.

Product royalties

The makers of one product can license its use with another product to receive a royalty. The product using the licensed product benefits from its association with the licensed product, such as PC manufacturers licensing an operating system to install on the computers they sell.

Resources royalties

Landowners can receive royalties for allowing businesses to use their land to generate profit, such as  drilling for oil or allowing cattle to graze. 

Franchise royalties

As mentioned above, franchises are another common form of royalty in business. Perhaps the most famous franchise in the world is the McDonald’s fast-food chain. Each restaurant’s operator pays the corporate franchise owners of McDonald’s a royalty percentage to use their branding and business model, as well as gain access to their supply chains and food products.

Calculating royalty percentages

Each unique licensing agreement will have different terms, but there are some general guidelines that can clue you in as to what to expect. The royalty rate in food franchise licensing agreements, for example, will usually be between 4% and 12% of revenue. Musicians and authors can usually expect between 2% and 10% from their publishers.

Patent owners can usually set their own rate and will be able to demand a higher royalty for exclusive rights to their patents.

Licensing agreements will usually include a minimum and a maximum royalty payment, or a specified period of time for payments. Some licensing agreements use a variable percentage rate, which means the royalty due is lower when sales are low, but rises when sales increase.

The percentage can be calculated on net revenue, gross sales or even simply on the number of units sold during the licensing period.

We Can Help

If you’re interested in finding out more about copyright and royalties in business, or any other aspect of your business and its finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.