Bright Ideas

Royalty Rules

Royalties determine how you get paid when you license your idea. The royalty amount depends upon myriad factors, including patent and prototype status, industry standards and more. It's fairly common for the licensee to advance some upfront payment against future royalties.

There are two royalty options:

1. Lump sum: This is when you sell your license for a onetime payment. This less common form of payment is usually used to compensate an inventor for releasing his or her rights to the idea.

2. Usage royalty: In this arrangement, payments are tied to the ongoing use or sale of the licensed idea. This is a more common payment method. With this type of royalty, the upfront payment to the licensor is usually smaller or nonexistent because of the uncertainties of future use or sales.

If you plan to let the licensee market your idea, royalty payments are usually calculated based on the number of units the licensee sells. There are several ways to determine this.

*You may choose to receive a percentage of the net selling price. This is known as the percent-of-sales method. This is a good solution if the net selling price is hard to determine upfront or if there is a possibility the product price will change. This method gives you an advantage in times of rising prices. Be sure to define how the net selling price will be calculated. Are commissions, discounts and shelf costs deducted when the amount is determined?

*Another way to calculate royalties is the fixed-amount method. A fixed amount of money is paid to you for every unit sold. This method is easy to calculate and implement. However, if the selling price is difficult to determine at the outset, you may be selling for a smaller amount than you need to. A benefit to the fixed amount method is that it insulates you against price decreases.

*The third way is the profit-sharing method. You and the licensee agree to split the profits from each unit sold. This approach is rarely used because it means you are subject to the whims of the licensee's accounting practices.

Clearly define the variables in your royalty calculation, but be open to as many selling opportunities as possible. For example, if you invented a new rubber compound for tires but your product could also be used in rubber hoses, you wouldn't want to limit the royalty payments to the sale of tires; you'd want to define your royalties subject to anything containing your compound.

Royalties are typically payable quarterly, usually within 30 or 45 days after the end of each quarter. In most cases, the licensee prepares a report detailing the royalty calculation.

The last but most important element to consider when you're negotiating is whether you can live with the terms of the agreement. Don't feel you must win on every point; only insist on the ones that are most important. The best deal makers always let the other side feel like they scored, too. Any contract is like a marriage. If you want it to work, you have to be flexible.

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This article was originally published in the July 1997 print edition of Entrepreneur with the headline: Bright Ideas.

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