What are royalty payments?

Typical assets associated with royalty payments include:

• Patents
• Trademarks
• Franchises
• Technology
• Minerals and resources
• Books, and
• Music

How do royalty payments work?

The terms of a royalty payment are detailed in a licensing agreement between the entity that wants to use an asset and the owner of that asset.

Note that the owner of an asset may be:

1. The creator or producer of the asset, or
2. An entity that has acquired the asset from elsewhere.

In general, a license agreement should include these elements.

Scope of the license

Defining the scope of the agreement is a crucial first step because it outlines the boundaries and limitations of the usage of the asset.

One primary consideration is geographic scope. In other words, does the license apply to worldwide use or is it limited to a specific state, territory, country, region or continent?

It is also important to define:

• The asset itself.
• The specific industry or sector in which the licensee is permitted to use the asset.
• The types of products permitted to be developed, manufactured or sold by the asset.
• The length of time the license is valid plus conditions where the agreement may be renewed or terminated.
• Exclusivity and the option to sub-license the asset, if applicable.

Payment terms

The payment terms section outlines how (and when) royalty payments will be made from the licensee to the licensor.

Royalty rate

This is often based on a percentage of the revenue or profits an asset generates over time. However, there do exist several other ways to determine the rate:

• A fixed fee per unit sold – common for physical products and resources.
• A fixed fee – often used for stable or predictable revenue streams.
• A combination of fixed fee and percentage. For example, McDonald’s franchise owners in Australia must pay a fixed license fee of $60,000 plus monthly royalty payments of 5% of total sales.
• Tiered royalties – this method uses different royalty rates for different levels or tiers. It is sometimes used to incentivise more sales or reward increased usage of the asset.
• Advanced payment – where the licensee pays an upfront fee that is credited against future royalty payments.
• Performance-based – where payments are based on specific targets or milestones outlined in the agreement.

Payment frequency

The frequency of payments outlined in a royalty agreement depends on several factors. This includes:

• The nature of the asset – for example, software royalties may be paid monthly in line with the typical subscription billing cycle.
• Businesses practices and industry norms – entertainment-related royalties are often paid quarterly or biannually since this is when media distributors report sales data.
• Financial management – licensees with stable and predictable cash flows may prefer more frequent royalty payments to better manage their budget, and
• Contractual negotiation – often, the payment frequency is determined by the size of the deal and the bargaining power of each party.

Reporting and auditing

Reporting and auditing promotes transparency, accuracy and accountability between the licensor and licensee.

To determine exact royalty payments, licensing agreements should clarify when (and how often) sales, usage or production figures are disclosed.

Reports also help verify the performance of the asset and build trust between the parties. Clauses in the agreement may permit the licensor to audit the licensee’s records as well as dictate how often they can do so and under what circumstances.

What’s more, clauses may outline how discrepancies in the data are handled.

Legal and compliance

These provisions encourage both parties to adhere to applicable laws and regulations while also protecting their respective rights and interests.

Ownership clarification

Licensing agreements should state that the licensor retains ownership of the intellectual property (IP) being licensed. That is, the licensee is only granted the right to use the IP and does not take ownership of it.

The licensor may also include provisions about actions they may take to protect their IP from authorised use (either by the licensee or a third party).

Compliance with relevant laws

In the context of a royalty payment, compliance relates to IP laws, commercial laws and any other industry-specific legislation.

Licensing agreements may also identify the legal jurisdiction which determines which country or state laws apply in the event of a legal dispute.

Other aspects of legal and compliance

Here are some other key parts of the legal and compliance section:

• Indemnification – in some cases, the licensor will cover legal costs if a claim is made against the asset in question.
• Dispute resolution – this process may involve negotiation, mediation or binding arbitration. But if these fail, the agreement will specify how court proceedings should be handled.
• Confidentiality – where both parties agree to keep any information private. In a royalty agreement, this may be business plans, trade secrets and proprietary technology.

Five types of royalty payments

Let’s finish with a more detailed look at five types of royalty payments and some examples for each.

1 – Music royalties

Music royalties are payments made to songwriters, composers, artists and record labels whenever their music is used, performed or sold.

Within this royalty type are several sub-types:

1. Mechanical royalties – paid to songwriters and composers whenever their music is reproduced or distributed (this includes physical and digital formats). In 2024, for example, musicians earned a 4 cent-per-minute royalty for songs of less than 5 minutes in duration.
2. Performance royalties – paid when music is publicly performed.
3. Synchronisation royalties – paid when music is used as part of a movie, television show, commercial or video game.
4. Print music royalties – for the sale of sheet music, and
5. Neighbouring rights royalties – these are paid to musicians and record labels when their recorded performances are played on the radio or in a public space.

2 – Patent and trademark royalties

Patent royalties are paid to inventors (or patent owners) for the rights to their invention(s). Similarly, trademark royalties are collected by the licensor when the licensee wants to use their trademark.

The latter is commonly used by Disney as part of its merchandising strategy, where it allows other companies to produce items featuring Disney characters.

Patent and trademark royalties typically comprise a one-time licensing fee or percentage of revenue generated by the patented product or trademarked brand.

3 – Mineral (resource) royalties

Mineral royalties are paid by companies that extract minerals from a property to the property owner. In Australia, the property owner tends to be the Crown and not a private landholder.

The actual royalty rate depends on the mineral type. In South Australia, for example, the rate ranges from 3.5% of the mineral’s value for refined minerals up to 5% for mineral ores and concentrates.

In other states such as Queensland, the royalty rate may be a flat rate per tonne or reflect the current metal price. Rates can also differ according to whether a mined commodity is consumed within the state.

4 – Publishing royalties

Publishing royalties are payments made to authors, writers or creators for the use or sale of their written works.

The most common example of this type of royalty payment is a percentage of total book sales. Authors may also receive a lump sum payment before publication of the book which is, in effect, an advance of future royalties.

What’s more, royalties can encompass subsidiary rights. This includes books that are adapted into movies, translated into different languages or released as audio versions.

5 – Royalty financing

Royalty financing is a somewhat left-field type of royalty payment where an investor provides capital to a business in exchange for a percentage of the company’s future revenue.

Royalty financing is used to fund projects that require substantial upfront capital in the production, music and digital media industries. It’s also used in:

• Technology and software – many businesses in this industry (particularly startups) experience unpredictable revenue early on and need a solution to fund growth.
• Natural resources – where investors provide capital to fund exploration projects to later collect royalties on revenue generated from extracted resources, and
• Pharmaceuticals – royalty financing also plays a major role in drug development and commercialisation. Small biotech startups pay royalties to backers once a drug hits the market, while larger firms also license their patented products or technologies to others.

Summary:

• A royalty payment describes financial compensation made to the owner of an asset (the licensor) by another party (the licensee).
• The terms that dictate royalty payments are set out in a licensing agreement. These documents clarify the scope of use, payment terms, payment frequency and procedures for reporting, auditing, compliance and conflict resolution.
• Some of the more recognisable royalty types include music royalties, mineral royalties, patent and trademark royalties, publishing royalties and royalty financing – where investors fund start-ups in exchange for a portion of future revenue.