Royalty Payments

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An inventor gets paid after a product is licensed by receiving royalty payments from the licensee.  Generally, manufactures and distributors who sell the licensed product must pay a percentage of the sale proceeds to the inventor.  In a licensing agreement, the patent owner retains ownership but allows the third party to manufacture or distribute the goods for a fee.

How Royalties Work

Generally, royalties work by a licensor/inventor contracting with a licensee to allow the licensee to manufacture or sell a patented product in exchange for royalties.  Usual and customary royalties are around 5% of net sales of the licensee to be paid to the licensor.  In certain industries and situations (i.e. the automotive industry and the pharmaceutical industry), the royalties paid to the licensor may be significantly higher than 5%.  Royalty payments allow the licensor to benefit from another party utilizing their intellectual property, and allow the licensee to profit in beyond the amount paid to the licensor.   The key for the licensee is profitability and weighing the amount of work required with the amount of profit expected.  If royalties are too high, the licensee may decide that the arrangement will not be profitable and may decide not to work with the licensor.  Generally speaking, and licensing agreement that gives the licensor/inventor greater than 25% of the total profits to the inventor is effectively pricing itself out of the licensee market, 

Lump Sum

Instead of royalty payments, a licensor may be given a lump sum in exchange for allowing a licensee to use their product.  However, generally speaking, lump sums are viewed as advances on royalties instead of a bonus or in addition to royalties being paid by a licensee.  Lump sum payments are more common in assignment situations where a one-time fee is paid to the patent owner in exchange for all ownership rights over the intellectual property.

Understanding Sales

Understanding sales is an essential element for the inventor and the licensee.  With most patent licenses, the inventor (licensor) is paid by the licensee based on royalties from sales.  The licensee must keep track of annual sales carefully and pay the percentage stipulated in the licensing agreement.  The payments for sales in a year should be paid by the licensee to the licensor within a month after the year ends.  In order to ensure that the licensee is paying the appropriate amount of royalties, many licensing agreements include provisions that allow the licensor/inventor to audit the books of the licensee on a regular basis.  If there are discrepancies in the books and records of the licensee and the amount of royalties paid, the licensee will be liable for the cost of the audit and deficiency fees in situations where the licensee has underpaid by 5% or more.

Taxes

Royalty payments are generally paid on the total net sales amount, but there are certain amounts that can be deducted from the net proceeds.  Allowable deduction from the net sales amount include:

  • Duties and sales taxes that were actually incurred and paid by the licensee;
  • Normal and usual discounts actually granted;
  • Feeds paid to the licensee associated with packing, shipping and insurance of products sent to individual customers.

While taxes can be withheld from the net sales amount, the licensee should still include the amount of taxes paid on the statement given to the licensee so that there is mutual understanding of the accounting methods used to arrive at the final annual net sales amount.

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