Royalty
A payment from a licensee to a licensor in consideration for the use of intellectual property. Common structures include running royalties (percentage of revenue or per-unit), lump-sum or paid-up royalties, minimum annual royalties, and milestone payments. Royalty base, deductions, audit rights, and reporting cadence are heavily negotiated.
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. An open-ended category such as "or other reasonable deductions" leaves room for dispute over what qualifies. Licenses commonly address affiliate transfers and intercompany sales so that royalties cannot be avoided 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.
Drafting points that bear on royalty disputes include a specific deductions list, defined "net sales" with no residual category, mandatory affiliate-transfer pricing, and detailed audit mechanics. Licensors often seek minimum royalty floors in place of "best efforts" or "commercially reasonable efforts" obligations, because an efforts covenant without a dollar floor can lead to disputes over what efforts were reasonable.