Most of today's licensing agreements are based on the payment of a royalty to the licensor by the licensee. The royalty is a percentage based on a sales price of the goods (the wholesale price if the product is sold at wholesale and the retail price if it is sold at retail). This sounds simple, but numerous difficulties often arise in negotiating and interpreting royalty rates, primarily pertaining to the rate basis, payment timing, advances against royalties, guarantees, and auditing. It's vital for both licensors and licensees to be aware of the issues and understand how certain contractual provisions can affect their bottom lines.

Playing the Percentages The actual royalty rate (the percentage number) is not usually a subject for debate. Each industry has developed certain parameters into which most deals fall. The type of licensed property, such as art, celebrity, collegiate, corporate, designer, character/entertainment, event, or sports, frequently determines the range of royalty rates (see chart).

Royalty Ranges

A much larger problem is whether royalties are due on goods shipped but not paid for by a licensee's customer. Of course, the licensee takes the view that it has already lost money by its customer's non-payment and shouldn't have to pay a royalty. On the flip side, the licensor feels it is entitled to be paid regardless of the receipt of payment by a licensee's customer. The reasons are twofold. First, once the licensed products enter the stream of commerce, the licensor has fulfilled its obligation. Second, the licensor does not want to be in the business of guaranteeing the credit of the licensee's customers. The licensor has no say as to whom the licensee sells to or whether it is choosing to take a credit risk, be aggressive in collection, etc. The licensor feels that since the licensee is receiving anywhere from 85 to 97 percent of the revenues, a sum should be put aside for uncollectibles.

Sum vs. Parts Another factor in royalty rates is whether they will be paid on the gross or net figures. Few contracts pay on "gross." There is no magic or standard format for figuring out what the "net" should be. Certain sums traditionally are subtracted from grosses such as returns and shipping/ handling (when the customer pays a separate fee for the shipping and handling, but the payment is incorporated in the overall payment). After these two fairly standard deductions, all others are up for negotiation. It is in the licensor's interest to have as few deductions as possible, although licensees may come up with new items they want to claim as non-compensatable and not part of the royalty basis. This issue can be very problematic when a licensed product is bundled with other products. Licensors may request the royalty be based on the total bundled item price, not on the portion attributed to the licensed product alone.

For example, in art licensing, it is always a contentious negotiating point when the licensed product is the print, but the licensee sells the print matted and framed. Is the royalty to be based on the total matted and framed price or just the print's value? Most art licensors will argue the royalty should be based on the total package. Licensees argue with equal conviction the royalty should be based only on the pro-rata value of the print.

A point of growing dispute is Free on Board (FOB)-based royalties, particularly with imported goods. As more and more licensees are taking possession of their goods in foreign ports, they are trying to peg the royalty rate on the cost of the goods once they are on the ship in the foreign port, FOB. There can be a great difference in the royalties. The wholesale price is the price the licensee sells to the retail stores, while the FOB cost includes getting the goods on the ship bound for the U.S. (e.g., what they have paid the factory for the goods, the cost of getting it from the factory to the ship, packaging, container costs, export duties, and taxes). The difference between the two pricing systems is the licensee's profits and the additional costs built into the wholesale price from the time the licensed products are shipped from the Far East, for example, until they are delivered to a licensee's customers. These differences can be substantial. If the royalty is not adjusted upward for an FOB transaction, the actual royalty being paid to the licensor (if based on the same percentage point such as 6 percent) is significantly less than the standard wholesale royalty. There is no universal answer for what multiple should be used to equalize the differential, so the licensor does not lose money by having the rate pegged at FOB. The most common solution is probably to multiply the wholesale royalty rate by three; however, that is certainly not universal. Licensors can and should, in the course of negotiations, find out the wholesale price and the FOB price, and do the mathematical calculations so the net royalty numbers come out roughly the same.