Royalties are compensation paid to a party in exchange for the use of its asset; the transaction is typically called licensing. The most common assets for which royalty payments are made are intellectual property and intangible assets. Examples of intellectual property include trademarks, patents, and copyrighted work such as books, poems, songs, plays, scripts, music, software, and movies. For example, if a movie production company wants to use a song in their movie, they may enter into a licensing agreement with the owner of that song. Royalties are also paid for the right to appropriate gas or mineral deposits. For instance, if a company wants to mine gold from a person’s land, the company might negotiate to pay the landowner royalties for every ounce of gold found.
Royalties are usually agreed upon during contract negotiations between the owner (licensor) and the party using the asset (licensee). If the creator has previously sold the intellectual property, the new owner can enter into new contracts for use. Under U.S. law, royalties are personal property and can be transferred to another party contractually or upon death.
Royalties are usually calculated as a flat fee, fixed amount per unit sold, or a percentage of revenue or net profit. Flat-fee royalties can be either assessed at the time of purchase or as a fixed amount paid at regular intervals such as annually. For example, the owner of a baseball team may be compensated $4 million per year for the use of the team’s logo on hats.
Fixed-amount-per-unit royalties are assessed as a previously negotiated price for each unit of a good sold using the asset. For instance, the baseball team owner may negotiate a $3 royalty for each hat sold. Percentage royalties are assessed as a portion of either the revenue generated by the final products or the net profit. For example, the owner of a baseball team may negotiate a 35 percent royalty for all merchandise sold with the team’s logo, based on revenue, or a 45 percent royalty based on net profit. The royalty payment to the owner of the baseball team varies greatly depending on the structure of the agreement and the method of assessing the royalty.
A party may license intellectual property from competitors, paying royalties to both. In this case, the licensee has economic incentive to maximize revenue by only promoting the intellectual property that provides the highest gain over cost (margin). To ensure that the licensee uses the intellectual property, a licensor may stipulate a minimum royalty in addition to a percentage of revenue or amount per unit sold, regardless of the level of sales. This provides incentives to the licensee to promote and use the intellectual property.
The use of royalty payments ensures that creators of intellectual property and intangible assets are compensated for their work. The use of royalties also allows people and firms with valuable intellectual property to expand into new markets despite such barriers to entry as a lack of capital or ownership regulations. Consequently, the ability to obtain royalties for intellectual property and intangible assets encourages international trade.
Intellectual property rights and regulation enforcement vary by country. In the United States and the European Union, if a party uses intellectual property without compensating the owner, the party can be sued for grievances and lost revenue by the creator or owner. This is not the case in countries with weak intellectual property rights such as India and China. The variation in intellectual property rights enforcement reduces the efficacy of royalty-based incentives for intangible asset creation. For example, firms are less likely to do business in countries where management perceives that their assets may be stolen because of lax regulations or poor enforcement. The prospect of lost economic value because of weak regulations has driven some countries to initiate legislation to grant additional intellectual property rights and improve enforcement.
In 1967, the World Intellectual Property Organization (WIPO) was created as a specialized agency of the United Nations to promote intellectual property protection worldwide. Currently, 184 nations are members that meet to establish intellectual property regulations and administer 24 treaties.
- Einer Elhauge, Do Patent Holdup and Royalty Stacking Lead to Systematically Excessive Royalties? ( John M. Olin Center for Law, Economics, and Business, Harvard Law School, 2008);
- Internal Revenue Service, “Royalties,” www.irs.gov (cited March 2009);
- John H. Mutti and Harry Grubert, The Effect of Taxes on Royalties and the Migration of Intangible Assets Abroad (National Bureau of Economic Research, 2007);
- Raymond T. Nimmer, Licensing of Intellectual Property and Other Information Assets (LexisNexis, Matthew Bender, 2007);
- Ben O’Hara and Mark Beard, Copyright, Royalties & Publishing (Wise Publications, 2006);
- Rey Sanchez, Making Cents of Royalties in the Music Publishing Business (Sound Business Publications, 2004).
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