What are royalties in business?
As a business owner, you need to know what is royalties’ definition and how the meaning of royalties applies to your company. Royalties are fees that one party pays to another in exchange for the use of their intellectual property, land or rights. A person or company can license their ideas, giving other people or companies permission to use their logos, trademarks or products themselves. Royalties are usually a small percentage of business revenue that can be paid out for a certain time period or in perpetuity. They can be negotiated case-by-case to adhere to the needs or wishes of both business parties involved.
Why are royalties important to business owners?
Royalties in business can be mutually beneficial for both the party who owns the intellectual property and the party who wants to use it. Your business can profit from the use of an idea, product or brand name while enjoying the legal protections of a licensing agreement. You can also earn royalties for your business by licensing your own intellectual property.
Royalty financing occurs when a business owner agrees to pay an investor a royalty in exchange for upfront funding. It’s a common way of raising capital to expand a business in exchange for a percentage of profits. Business owners who own and operate a franchise location pay a royalty to the franchise owner in exchange for the use of their business model, branding and products.
Related: How to Get Business Funding
How do royalties work?
Business owners agree on the percentage or flat-rate royalty amount in a licensing agreement that they sign with the owner of the intellectual property or assets. Each licensing agreement or royalty contract should have a description of the intellectual property being licensed and details on how the payment amount will be calculated. It’s wise to hire an attorney to help you understand the legal and financial details of your licensing agreement.
Determining royalty costs
Every licensing agreement has different terms, including a minimum royalty payment, maximum royalty payment or timeframe for payments. Some royalty payments are based on a variable percentage, meaning that the royalty percentage is small when sales are low and increases when sales are high. Royalties can be paid out based on the number of units sold or as a percentage of net revenue or gross sales.
How much do franchisees pay in royalties?
Royalty costs for franchisees can be anywhere from 4% to 12% of revenue depending on the type of business. These fees are usually collected by the franchisor monthly and are based on a percentage of your total revenue. High-volume franchises, like food franchises, usually have the lowest fees. These monthly royalty payments are where franchisors make their money because over time, they exceed the upfront franchise fees.
Examples of royalties in business
Natural resources, patents, copyrighted content, trademarks and franchise branding are all examples of intellectual property that can be licensed in return for royalties. Here are some examples of how royalties work in business:
Artistic royalties
Musicians receive royalties any time someone wants to use their music in public or in a commercial. Authors also receive artistic royalties for letting publishers distribute their books. Artists usually receive royalty rates of 2% to 25% from publishers depending on the industry. While music royalties are commonly 10% to 25%, traditional writers typically don’t receive more than 10%-15% from publishers for novels in trade paperback or hardcover. However, writers who choose to self-publish can receive royalties of up to 70%. Similarly, authors will make more royalties off an ebook than a paper copy of a novel because the ebook is less expensive for the publisher to produce.
Patent royalties
If you have an invention with a patent, you can license your idea to manufacturers and earn royalties on the revenue they earn. Patents are common across all industries and are especially prominent in technology and the creative arts where original ideas and innovations must be protected by the creator. If someone invents a unique device for servicing ice cream machines and they patent that device, other companies that want to start using that device for their ice cream machines must enter into an agreement with the inventor. Some companies may want to buy exclusive rights to your patent, but sometimes businesses are able to license their patent to multiple companies.
Trademark royalties
When business owners print a trademarked name or image on their products, such as hats and T-shirts, they have to pay a licensing fee. For example, a sports team like the Nets trademarks their logo and a clothing company wants to put that logo on their sweatshirts. They must pay the Nets or the NBA to use the trademarked logo on their items.
Finance Royalties
This type of royalty means that you invest in a business and get money based on its future revenue. Therefore, finance royalties depend on an individual’s investments. Royalty financing is similar to a loan in that you get royalties paid to you instead of having an equity stake in a company.
Franchises
As a franchisee, you may have to pay royalties to the franchise owner to use their name. Royalties are a regular business expense for franchise owners, who must pay a royalty as part of their franchise agreement. Franchisors collect fees from all of the locations licensed to use their business model and brand. They use those payments to create products, fund marketing campaigns and pay administrative employees at the main headquarters.
Mineral royalties
Mineral royalties are also called mineral rights and are paid to property owners by mining and petroleum companies working on their land. If you are a business owner extracting minerals, you will typically pay the property owner a percentage based on your revenue or the units of minerals that you’re harvesting.
Frequently asked questions about business royalties
What are royalties in business?
The business royalties definition can either refer to a payment that you make to another company for use of their protected ideas in your business, or a secondary income stream that your business generates from licensing out its own intellectual property.
How are royalties calculated?
Royalties are usually calculated based on a set percentage of revenue. Multiply the total revenue from the intellectual property by the agreed-upon decimal percentage to find the correct amount.
How do royalties work with franchise businesses?
Franchisors usually collect royalties on a monthly basis. Unlike other businesses that may only pay royalties on a particular item, franchise royalties involve all business income because they are licensing an entire brand and business model.
Are royalties an expense?
If your company is paying royalties to artists, creators or other individuals, your royalties incurred by the company are considered an administrative expense. Whether or not these expenses are tax-deductible depends on how the royalties correlate to your business.
Do royalties count as income?
Yes, royalties count as taxable income when they are paid to you for the use of your physical, intellectual or creative property. If you receive royalties for the use of your property, you are required to claim them as part of your annual business income. Typically, this is done on Form 1040 or Form 1040-SR, available online through the IRS website.
