Royalties Explained: A Comprehensive Guide to Their Impact in Business

A royalty investment can benefit both the business and investor.

Musicians, actors, and authors often receive a small fee each time their creative output is viewed or sold, with the personal net worth of top performers affirming the value of royalties. In the realm of business financing, some owners choose the self-funding (bootstrapping) route, others choose debt financing and take out loans, while others offer a percentage of their business to investors in the form of equity to secure financing. Royalty agreements offer a less common albeit potentially beneficial option.

In this blog post, we explain how royalties work, their significance and common uses, and some important legal considerations related to royalty agreements.

What are royalties in business?

Royalties are payments for the current or future use of an asset or intellectual property. For example, an individual or company can license or franchise their products, trademarks, or natural resources for other parties to use in exchange for a fee. Royalty payments are typically based on a percentage of revenue, which can occur over a defined period of time or in perpetuity.

How do royalties work?

In simple terms, a royalty is a payment for the use of property. When a business raises capital through a royalty investment, they typically offer a portion of the company’s future revenue in exchange for an upfront cash infusion. For example, if a company sells cars, the royalty agreement might require the business to return $100 per car to the investors after each sale. There’s usually a short grace period in place before the company must begin making royalty payments. This allows the impact of the funding to be felt before the payback period begins.
Some of the more common types of royalty agreements include:
● Patent royalty arrangements whereby inventors license their intellectual property (IP) and collect a fee each time it is used.
● Performance royalties where artists collect a fee when their material is played over the airwaves.
● Franchise fees where business owners pay for the right to open a business under the umbrella company brand name.
● Mineral royalty agreements that allow landowners to collect a portion of the revenue provided by the sale of minerals (oil, diamonds, coal, etc.) mined on their property.
Royalty agreements can be either fixed duration or perpetual. A fixed duration royalty agreement ends after an agreed-upon number of days, units, or dollars, whereas a perpetual agreement guarantees a royalty payment to the investor as long as revenue is generated. Perpetual agreements tend to favor the investor, especially when the product or service has a long useful life.

Common royalty uses and industries

The software industry relies on royalties paid by product manufacturers and other users to keep development firms profitable. The software royalty model began to take shape in the early 1980s, when pioneering software companies like Microsoft developed proprietary software that hardware manufacturers like IBM built into mass-produced personal computers. Since software has no tangible form, licensing agreements and royalties based on units sold emerged as logical business models.

Royalty investments are also a prudent option for investors who don’t have a clear exit strategy when the owner shows little interest in reselling the business in the future. For example, a promising new food company could be offered a lump sum by an investor in exchange for 1% of all gross sales, until the initial investment is doubled. This limitation creates a hard stop while supporting a sizable return for the investor.

Calculating royalty rates

Establishing fair and competitive royalty rates is extremely important since it can determine whether the influx of capital is worth the reduced profits over time. Factors to consider when establishing a royalty rate include the current demand (or lack thereof) for the product or service, the uniqueness of the product or IP, the duration and terms of the agreement, and the current or expected profit margin. The methods used to calculate royalty payments include:
● Fixed percentage methods based on an agreed upon and unchanging percentage of the profits.
● Variable percentage methods that are subject to change based on factors like total revenue or cost of goods sold (COGS).
● Fixed-value royalties based on a dollar amount that does not change when the sales price increases or decreases.

Royalty legal considerations

A royalty agreement is a legal contract between the business owner and the investor, so it is advisable to consider the impact of all terms and conditions and consult with an attorney on all important points. When the licensing of intellectual property is included in the agreement, the royalty agreement will also prevent patented inventions and trade secrets from being used or shared inappropriately. Additional legal considerations related to royalty agreements include:
● Exclusivity terms that dictate whether the IP holder can seek similar arrangements with more than one partner.
● Payment terms that dictate what, when, and how royalties are to be distributed.
● Confidentiality and non-disclosure agreements to ensure all information exchanged remains private.
● Termination terms and conditions that specify the length of the contract, grounds for termination, and renewal options.
Using clear and precise language, explicitly stating the royalty calculation method, defining the governing law that applies to the agreement, and outlining dispute resolution steps are some additional legal best practices to be considered.

In conclusion

Unlike other investment options, royalties provide a mechanism for investors to obtain a return that is directly proportional to company revenue, while allowing business owners to remain in full control of company governance and strategy. This model has been successfully applied to products and services of all types, but the emergence of the software industry over 40 years ago demonstrated the full potential of royalties in business. The licensing of IP ensures innovators are properly compensated while protecting their inventions from copycats. By calculating appropriate royalty rates and carefully considering the legal implications, both investors and business owners can benefit from royalty agreements.

Royalties in business FAQs

Can a royalty investment impact my company’s valuation?

A contractual obligation to pay a percentage of sales revenue to investors impacts the profit margin and bottom line, which in turn impacts the company valuation. Companies with variable pricing models are better able to mitigate the impact of royalties.

Is a royalty considered equity or debt?

A royalty financing arrangement is neither equity nor debt. The borrower’s equity stake is not affected by a royalty investment, and they maintain their existing debt levels. Since the business owner remains in control of the company and investors benefit from improved sales, royalty arrangements can become a win-win proposition.

Can licensing deals help you expand your business?

A licensing deal can help you grow your business, especially when the demand for your products exceeds your current capacity. Granting the rights to your brand and products to a licensee can help you to alleviate these constraints while potentially expanding into new markets.

Are royalty agreements similar to debt financing?

By taking on a royalty investment, you are agreeing to pay back investors using a portion of your company’s revenue for a specified period, or until you reach a predetermined limit. Since both methods require businesses to repay the investors, there are some similarities with debt financing.

Do you need to have a proven track record to obtain a royalty investment?

Companies with demonstrated sales history have an easier time securing royalty investors, but many newer companies have also pursued this strategy. In lieu of a proven track record, a strong sales pitch and a novel invention may convince investors that a royalty investment will be lucrative.