How royalties are calculated


Lukas Balciunas, Manager

Royalty rates refer to payments that are made when a licensee uses a licensor’s intellectual property (IP), as per a license agreement between the two parties. As the Organisation for Economic Co-operation and Development (OECD) states, “Copyright, trademark and patent holders may license others to use or produce the good, usually in return for a fixed payment and a royalty rate” (Glossary of Industrial Organisation Economics and Competition Law).

Types of intangibles that may require royalty payments include “literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience” (The OECD’s Model Tax Convention on Income and on Capital, 2014).

How are royalties calculated?

The way a royalty is calculated depends on the license agreement relating to the intangible in question. Usually, it is calculated as a royalty percentage – a portion of the gross or net revenue gained through the exploitation of the licensor’s IP. It can also be expressed as a fixed value. In this case, a sum will be decided on at the start of the agreement and will not change throughout the term of the licensing contract. There are benefits to both methods, with the selected royalty one depending on the organization in question and the preferences of the individual licensor.

Royalty percentage

Agreeing on a royalty percentage is the most common approach when it comes to contracts and license agreements between the licensee and licensor. This method tends to be more financially convenient for the licensee as the amount they pay reflects their current business situation. For example, if the licensed IP is not yet particularly profitable, then the licensee will only have a small royalty payment to organize. Once the IP starts to generate increased revenue, the royalty payment will increase proportionally, so the licensee is in a position to pay it. A royalty percentage is also generally more lucrative for the licensor, as it means that they get a greater return on investment in the long term as the licensee’s business grows.

Fixed value royalty payment

A fixed value royalty stays the same for the duration of the license contract, regardless of whether the revenue generated by the IP increases or decreases. A fixed value royalty fee means that, if the IP performs well and achieves quick and substantial rates of growth and profit, the licensee’s royalty payment will seem relatively low in the long term. However, if the organization’s profits relating to the IP do not increase significantly, the fixed value may not be advantageous. While the licensor’s return will not increase, a fixed value royalty does ensure a set amount of IP-related income, which can be considered financially beneficial.

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