Royalty rates and structures: finding the right balance

A royalty is what the licensee pays the licensor for the right to use its intellectual property. It can be a percentage of sales, a fixed sum for each unit sold, a lump sum, or a mix of these. The headline rate gets most of the attention in negotiation, but disputes more often come from the machinery around it: what the percentage is applied to, when it is paid, what happens if sales are low, and how the licensor checks the numbers.

Percentage royalties

The most common structure is a running royalty, calculated as a percentage of sales and paid quarterly or half-yearly. It ties the licensor’s income to how well the product does, which suits a licensee who doesn’t want to pay heavily before it has sold anything. Some licences use tiered rates, where the percentage changes once sales pass set thresholds. The tiers can go either way: a falling rate rewards the licensee for volume, while a rising rate gives the licensor a bigger share of a success. Make sure the licence says whether the higher or lower rate applies to all sales or only to sales above each threshold, because the difference can be large.

Fixed and lump-sum royalties

A fixed amount per unit is easier to calculate and audit, but it doesn’t move with price, so one side loses out when prices change. A one-off lump sum gives certainty and avoids ongoing reporting, but the licensee carries the risk that the product never sells. Many licences combine an upfront fee with a lower running royalty.

Defining what the royalty is calculated on

A percentage means nothing until you know what it is a percentage of. Licensors prefer gross sales; licensees prefer net sales, meaning the invoiced price less items such as VAT, returns, trade discounts, rebates and delivery costs. The definition should list every permitted deduction, say whether any are capped, and deal with sales to associated companies (usually by applying the price that would have been charged to an unconnected customer). Also check how bundled products are treated, where the licensed item is sold as part of a larger package, and which exchange rate applies to sales in other currencies.

Minimum royalties

A minimum royalty guarantees the licensor a set amount each year whatever the sales. It matters most in an exclusive licence, where the licensor has given up the chance to license anyone else and needs protection against a licensee that sits on the rights. If you are the licensee, find out what happens if you miss the minimum. It might mean simply paying the shortfall, losing exclusivity or having the licence terminated, and those are very different outcomes. Ask for a lower minimum in the first year or two while the product launches.

Reporting and audit rights

The licensor only knows what it is owed from the licensee’s reports, so the licence should require regular royalty statements showing units sold, gross and net figures and the deductions taken. A licensor should also have the right to inspect the licensee’s books, usually through an independent accountant, on reasonable notice and no more than once a year. The usual bargain is that the licensor pays for the audit unless it finds an underpayment above an agreed margin, in which case the licensee pays for it and makes up the shortfall with interest. As a licensee, ask for a limit on how many years back an audit can go.

Setting the rate, and other terms to check

There is no standard royalty rate. Published surveys and past deals can give a starting point, but the right figure depends on how strong and proven the IP is, how much of the product’s value it accounts for, whether the licence is exclusive and what margins the licensee can realistically make. If you are the licensee, model the royalty against cautious sales figures and see whether the business still works.

Beyond the rate, check when payment is due and whether interest runs on late payment, whether royalties stop when the relevant patent expires or the know-how becomes public, and, for cross-border licences, who bears any tax withheld on royalty payments. That last point is worth specialist tax advice.

QuickLegalCheck reviews your licence and flags loose definitions of net sales, one-sided minimums and missing audit protections. See how it compares with a solicitor or a general AI chatbot.