Royalty

A royalty is a payment from a licensee to a licensor in consideration for the use of licensed intellectual property. Royalty terms are a primary economic dimension of any license agreement. The four critical negotiation points are (1) royalty base, the dollar amount or unit count to which the rate applies; (2) royalty rate, the percentage or per-unit amount; (3) permitted deductions; and (4) audit and reporting mechanics.

Royalty structures

Common structures include: running royalty, a percentage of net sales or a per-unit payment, payable quarterly or annually based on actual sales activity; lump-sum or paid-up royalty, a single payment buying perpetual rights, eliminating ongoing reporting; milestone royalty, payment triggered by specified events (regulatory approval, first commercial sale, sales-volume thresholds); minimum annual royalty, a floor payment regardless of actual sales, common in exclusive licenses to maintain incentive; and tiered royalty, rate varies with sales volume.

Royalty base, net sales vs. gross

The royalty base provision is heavily negotiated. Licensors typically prefer gross revenue or list price as the base; licensees prefer net sales, gross revenue minus enumerated deductions for returns, allowances, discounts, freight, taxes, and packaging. The deductions list should be exhaustively defined; an open-ended "or other reasonable deductions" clause is a recipe for dispute. Affiliate-transfer pricing and intercompany sales should be addressed explicitly to prevent royalty avoidance through structure.

Audit and reporting

Standard practice: licensee delivers a royalty report each quarter or year showing units sold, revenue, deductions, and royalty due, accompanied by payment. Licensor retains audit rights at its expense, with cost-shifting to the licensee if the audit identifies an underpayment exceeding a stated threshold (typically 5%). Audit rights survive termination of the license for a stated tail period (typically two to three years) to allow review of the final royalty period.

Patent-specific limits

Under Brulotte and Kimble, patent royalties may not extend beyond the expiration of the last licensed patent. Royalty agreements that extract payment for use occurring after expiration are unenforceable as to that portion. Licensors with patent-and-trade-secret hybrid arrangements typically structure separate royalty obligations for each, allowing the trade-secret royalty to continue indefinitely.