Royalty rates vary depending on the intellectual property and industry. How the royalty rate is determined most often comes down to negotiating a royalty payment that works for both parties. Sometimes a low royalty is required because of slim profit margins, the IP is unproven, or the market is unknown. But what happens if your IP turns into a big hit in the marketplace? If you’re stuck with a low royalty rate, you can feel like you’re losing money.
Royalties is the term used for licensing payments. Royalties are structured in many ways including fixed, lump sum, quarterly, annually and as a percentage of sales. The royalty rate, however, doesn’t have to be the same for the term of the agreement. There is a way to increase the royalties as your licensing partner increases their revenues. It’s called tiered or adjustable royalty rates. It’s a strategy to boost the revenues earned from your licensing agreements.
Basically it works like this. The more your licensing partner sells, the higher the royalty rate is adjusted, up to a maximum amount. For example, it could be based on the revenues or sales units, and the royalty rate increases at certain increments. For example, the royalty starts at 6% and increases to 7.5% once the licensee reaches one million dollars in sales or a million units. It then increases to a maximum of 9% once they hit 5 million dollars (or units).
I recently negotiated several licensing deals for international rights to some popular movie franchises with tiered royalties. The royalties increased based on reaching certain milestones, either a level of sales or on a specific date, whichever occurred first. This was a good compromise. It gave my client a lower royalty initially to help recoup their investment in developing the property, and provided the licensor a higher average royalty over the term of the license.
This is just one example of using a tiered royalty rate and how it can increase royalty revenue. Tiered royalties let you tailor the financial part of the agreement to reflect market conditions. Keep in mind,determining a royalty rate depends upon a number of factors. It comes down to what is negotiated. One of the biggest factors is profit margin. What does it cost to generate sales and how much profit does the IP generate?
If your licensing partner has to invest a lot of time, money and resources to market and sell, then the royalty rate will be lower. That’s their risk. A tiered royalty rate is an option that solves this issue, enabling your licensing partner to build their sales, and pay you higher royalties as their revenues increase.