Royalties are a wonderful way for inventors to collect payment for the use of their inventions. Any time a song is played on the radio the song composer receives a royalty for their work. Any time an artist’s drawing is replicated the artist receives a royalty and any time an author’s published work is reprinted, the author too receives a royalty. Royalties can make the licensor extremely profitable, but only if the licensor understands how royalties work. It is important to not fall victim to the following traps when negotiating royalty terms.
1.) Establishing a royalty percentage does not guarantee a royalty income for the licensor. A company can license the patent rights of an invention for an exclusive licensing agreement offering the licensor a percentage rate of their income based off the use of the invention. However, if the company makes no sales, the licensor receives zero dollars. When negotiating terms, always establish a minimum guarantee income. That way the licensor guarantees himself / herself a pay check regardless of the licensee company’s performance.
2.) Avoid terms that involve royalty rates based off net profit. Royalty rates should always be off gross profit, not net profit. There are ways for companies to fudge net profit numbers to look less than they actually are. For instance, they can claim manufacturing and heavy discounting on products led to very little net profit for the year. It is a shady practice but one that is seen done. To protect their royalty payments, licensors should always negotiate terms that make royalty rates off gross profit, which is the profit earned before overhead costs are deducted.
3.) Always put in place remedy provisions into the licensing agreement. The licensor should mandate a remedy provision into the agreement that lets them easily terminate the contract if certain requirements are not fulfilled. For instance, if the company fails to generate a profit after a specified period of time, the license is revoked and reverts back under the control of the licensor.
4.) Lastly avoid royalty ceilings. Royalty ceilings are caps set on royalties. If a company meets a certain level of sales, than they do not have to continue paying royalties. This practice while sometimes is set up in exchange for a negotiated minimum income, is best to avoid. Royalties should always be paid on all sales.