Following the money in a royalty deal

Two offers arrive for the same design. One promises five percent, the other eight percent. The eight percent looks better until you notice that the two percentages apply to different amounts. Don't compare headline rates. Follow one ordinary sale through each agreement to the money that actually reaches you.

Find the amount the percentage applies to

Royalties come in a few standard shapes: a percentage of gross or net sales, a fixed amount per unit sold, a minimum payment due whatever the sales, and tiered rates that change as sales grow 1. Many deals combine a royalty with a lump sum 2.

Read the definition of net sales first. A gross figure allows no deductions for costs such as packaging and freight; a net figure subtracts costs such as shipping or customs, so the contract has to say exactly how net is worked out 2. Ask three questions of that definition:

• Which deductions are allowed, and is there a limit on them?
• Whose price counts: the licensee's, a distributor's, or a related company's?
• Which income is included: sublicensing revenue, bundles, digital sales? Royalties can be a percentage of revenue from products sold or sublicensed 2, so say which.

Here is an invented example. Five percent of $10,000 is $500. Eight percent of $6,000 is $480. If the second agreement lets the licensee deduct enough to turn $10,000 of sales into $6,000 of net sales, its higher rate pays you less. The rate means nothing until you know the base it applies to.

Run an awkward sale through the contract

Before you sign, take one normal sale and one awkward one (a discounted item, a return, a bundle, a sale to an affiliate) and calculate the royalty on each using the proposed wording. Then put the method in the contract: WIPO recommends specifying exactly how the royalty is calculated, including sample calculations in an exhibit to the agreement 2. A worked example in the contract settles arguments that would otherwise surface when the first statement arrives.

A per-unit royalty, a set amount for each unit sold, keeps the arithmetic simple 2. You still need to know which units count (ordered, shipped or paid for, and what happens to returns) and when payment falls due.

A minimum royalty guarantees you a baseline even if sales disappoint, and minimums are common in exclusive licenses 2. It is still a promise from the other party, not money in the bank. Agree what happens if they miss it; one option is to make the exclusivity depend on the licensee reaching minimum royalty payments or sales 2. Watch for the opposite clause too: a cap, where the licensee pays royalties only up to a fixed amount, limits what you can earn from a success 2.

Know what the upfront money is doing

An upfront payment is either a fee on top of royalties or an advance against them. A lump sum can be paid at signing or later, in instalments timed to milestones; an advance is offset against the royalties the licensee would otherwise pay you until it is paid off 2. Find out which one you are being offered. If it is an advance, ask:

• Which earnings are credited against it: this deal only, or other deals with the same company?
• Can any of the licensee's expenses be charged against it?
• If your royalties never reach the advance, do you keep the difference or owe it back?

An invented example: the contract says a $2,000 advance is credited against later royalties. Your first statement shows $600 earned, all applied to the advance. You receive nothing for that period, and $1,400 remains to be earned back before royalties are paid out again. Whether you could ever be asked to repay that $1,400 is set by the contract wording, not by the word "advance": WIPO calls an advance "in effect a loan" that royalties pay off, yet also notes that the licensor is guaranteed at least the advance even if the licensee fails to pay future royalties 2. Get the answer in writing.

Make each statement prove the payment

Define exactly how royalties are calculated and reported, and set audit rights and payment enforcement terms 1. Require every royalty statement to show:

• the period it covers;
• units sold and gross sales;
• each deduction, by type;
• the rate applied and the royalty earned;
• any amount credited against an advance, and the amount paid to you.

Also write into the contract when statements and payments are due, which currency you are paid in and at what exchange rate, how you raise a discrepancy, and your right to have the licensee's records checked. Agree when the rate can be renegotiated: WIPO warns against locking in rates that cannot be adjusted as markets or technologies change 1. For checking statements after signing, see The work after a deal is signed.

No single percentage is fair for every work, partner and market. The rate moves with the type and value of the IP, market benchmarks, exclusivity, territory, field of use, the licensee's risk and investment, and each side's bargaining power 1. Before you sign a deal with an advance, a minimum or an exclusive grant, have a licensing lawyer read the royalty and payment clauses and an accountant run your sample sales through them.