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I have been getting more and more questions about royalty agreements: what they are, how they work, how to negotiate them, etc. This is a typical question I got just the other day:

We are beginning negotiations for a royalty/license agreement. What is the customary way to value what we should receive as a royalty/license fee?

To clarify the subject, let's start with a simple explanation from answers.com:

Royalties are payments made by one company (the licensee) to another company (the licensor) in exchange for the right to use intellectual property or physical assets owned by the licensor. For example, software giant Microsoft invented the Windows operating system for personal computers as a means of managing files and performing operations. Computer manufacturers such as IBM and Compaq pay a royalty to Microsoft in exchange for being allowed to use the Windows operating system in their computers. Other common situations in which royalties are paid include the following:

1. In the fashion industry, designers such as Ralph Lauren and Calvin Klein license the right to use their names on items of clothing in exchange for royalties. For example, they may sign a contract with a company that makes jeans that allows the company to place the designer's name on the jeans.
2. In book publishing, authors are commonly paid both a fee for their services and a royalty rate that entitles them to a percentage of their books' profits.
3. In the music industry, royalties are paid to music copyright holders and to songwriters by radio stations and anyone else who derives a commercial benefit from the copyrighted material.
4. In the television industry, popular satellite TV services such as Direct TV and cable television services pay network stations and superstations a royalty rate so that they can broadcast those channels over their systems.
5. In the oil and gas industry, companies pay landowners a royalty rate for the right to extract natural resources, such as petroleum and natural gas, from the landowner's property. Similar agreements exist in the mining industry for minerals such as copper and silver.

Royalty agreements are intended to benefit both the licensor (the person receiving the royalty) and the licensee (the person paying the royalty). For the licensor, signing a royalty agreement to allow another company to use its product or intellectual property can mean expanding into a new market, or increasing market share in an existing market. For the licensee, the agreement can mean gaining access to products that may have been too expensive or too difficult to produce on its own, or that were protected by patents it did not own. If done right, the royalty arrangement is a win-win situation.

 

Royalty agreements generally are one of two types. The fixed price per unit agreement pays the licensor a set price for every one of its products sold by the licensee. Often, this type of agreement is used when the licensor's product is one that will be a small part of a larger product produced by the licensee. An example of this might be a new type of windshield wiper motor developed by Company A. The motor drastically changes the way windshield wipers work and is granted a patent by the U.S. Patent Office. Company A approaches General Motors and offers to license the motor to the automaker so that it can be included in all GM cars and trucks. In return, GM agrees to pay Company A $10 per unit for every motor it purchases. This price would cover the materials and labor needed to produce the motor, as well as include an extra sum to cover Company's A investment in developing the motor. In fixed price arrangements, the amount per unit can be adjusted for inflation, or a minimum royalty amount can be specified.

 

The second type of agreement is a royalty that pays a percentage of revenues or operating profit that results from the sale of the licensed product. This is more likely to be used when the item covered by the royalty agreement stands alone or when the cost of using the item can be clearly itemized. Percentage agreements are generally more intricate than fixed price agreements because more terms must be defined—what rate will be paid for discounted items, what happens to items that are returned, whether sales commissions affect the percentage paid, whether updated versions of the item are covered by the agreement, and more. Agreements based on a percentage of the operating profit generally result in a more equitable settlement for both parties, but those agreements are also more complicated. As a result, it is more common for companies to agree on a percentage of revenues.

 

In terms of negotiating the rate itself, there seem to be a few general "rules of thumb" to arrive at "fair" royalty payment:

1. The first is sometimes called the "25% Rule" and relates to how much one would expect to receive as Royalties as a percentage of the increase in profit that your intellectual property provides to the licensee's business.  This rule of thumb will often give the licensor about 25% of the profit made by the licensee from the exploitation of the intellectual property over the life of the license gives the licensor. This is only a guide and in at all to be considered to standard rate.
2. Another is the "5% of Net Rule" and is based upon a payment from the licensee to the licensor of 5% of the net selling price.  Much care must be taken here in terms of what "net selling price" means and how it is calculated.  This means Gross Sales less certain items such as Discounts and Returns, but could also mean less Advertising, Sales Costs, etc., so be sure to define this clearly in the agreement.

The are many key deal terms when negotiating a Royalty or License agreement are here are a few based upon the needs of each party:

 

	Licensee	Licensor
What each party wants…	Royalty revenue Recognition and visibility Brand extension Exploit manufacturers’ manufacturing and commercialization capabilities (including sales force) Require Development and Commercialization of Product	Brand recognition and cachet New fresh product to differentiate itself from the competition Tap new customer base Maximize manufacturers’ manufacturing and commercialization capabilities (including brand, marketing and sales force)
What each party is concerned about…	Reasonable Value Diligence on the Licensees' part Monitoring and reports Remedies (including having the asset revert to their control if certain minimums have not been met)	Manage overall financial risk Manage overpayment risk Cap development and marketing expenses Ability to terminate

 

Other tips on negotiating the agreement (from a presentation by law firm Cohen Tauber Spievack & Wagner) include the following checklist of items to include in the agreement:

 

The ideal “win-win” agreement should:

• Matches parties’ strengths to responsibilities and objectives
• Avoiding pitfalls of taking on responsibilities that cannot be financed or are economically unsound
• Time frames for obligations – an effective due diligence clause
• Recognize true market for ultimate product
• What are competing products?
• What sort of pricing will the market bear for the ultimate product?
• Recognizing what everyone is looking for and not overreaching means expressing in good faith abilities, expectations, goals, and desires during negotiating process

They also offered up the key agreement terms in a royalty agreement that need to be negotiated and clarified between the parties.  (You can start with by downloading a simple agreement template here, but you will obviously want an attorney to assist you with the final agreement due to its complexity:

 

License Grant and Restrictions:

• Exclusive
• Non-Exclusive
• Semi/Co-Exclusive
• Granting Clause
• Licensor’s Reservation of Rights

Territory: Worldwide or Specific Countries

• Infrastructure and Abilities of Partner
• Available Patent, Copyright and Trade Dress Protection
• Strategic Goals
• Certain Rights May be Limited to