It's one of the most commonly utilized commercial structures in various technology and intellectual property licensing deals: the royalty. As everyone's go-to payment mechanism for licensing deals, you may think that the nuances of royalty calculation and payment are well-defined and understood universally. But, time and again, we find that walking through a list of potential royalty "pain points" uncovers certain components of a contemplated royalty-based deal that have neither been considered nor agreed by the parties.
For that reason, we think it's a good time for a refresher on common points to be considered when entering into a transaction that will include royalties. While the specific terms governing a royalty will vary based on numerous factors, including the nature of the products and the underlying licensed materials and the contemplated commercialization structure, many concepts are useful across the board. Today’s entry focuses on issues related to defining the relevant scope of royalty calculations, while a forthcoming post will address issues related to royalty timing and reporting considerations.
Fixed Amounts vs. Percentage of Revenue
Royalties are often payable as a fixed amount per transaction (e.g., $1/unit sold) or as a percentage of revenue (e.g., 5% of net revenues). In each scenario, the parties should ensure that all relevant transactions, including, as applicable, direct sales, sales through distributors or resellers, leases, licenses, subscriptions, or other granting of digital access to the underlying product are specifically identified as sales subject to the royalty. Likewise, if there are any specific types of transactions that should be excluded or subject to a modified royalty, those should also be identified – for example, distribution as part of a limited pilot program or other free trial offerings are often excluded from the transactions included in the calculation of fixed amount royalties.
Gross vs. Net Revenue
Remember that not all revenue calculations are equal. Parties often have an inclination to gloss over definitions of terms like gross revenue or net revenue because each has a generally accepted understanding (as pre- or post-cost). But we urge you to pay close attention to the specific inclusions and exclusions from the gross or net revenue amounts included in the royalty calculation. Sales tax is an example of an amount often excluded for purposes of either revenue calculation. For net revenue–based royalties, consider whether it is appropriate to deduct things like distributor or reseller fees, payment processing fees, and overhead or other similar expenses to arrive at the net revenue amount. Specificity is often beneficial here, as general terminology such as "direct operating costs" can vary drastically in interpretation.
Revenue from Initial Sales, Renewals, and Add-Ons
For subscription-based products, consider whether there will be any distinction in royalty amounts between initial orders and subsequent renewals, such as an incrementally lower royalty percentage applicable to renewals. Also, where quantities can be adjusted and/or optional functionality or features can be added on after the initial sale, consider how those changes will be handled for purposes of calculating royalties.
Specific Revenue Exclusions
If revenue may consist of fees attributable to different components of an order, such as a subscription fee and maintenance and support fees, or a purchase price and customization or training services fees, consider whether any components of the transaction should be excluded for purposes of calculating the royalty. Often, non-recurring revenue streams such as implementation, training, or customization services are excluded from royalty calculations. Without specifically identifying which components are included and excluded, ambiguity often arises as to which revenues are included in the royalty calculation (under the rationale that they were received as part of a transaction related to the royalty-bearing product) or are excluded from the calculation (under the rationale that they were in consideration of ancillary services rather than directly attributable to the royalty-bearing product).
While the seller of the products ultimately wants to retain the discretion to discount its products as it sees fit, discounting can materially affect royalty calculations and therefore its effects should be carefully considered as part of the royalty calculations. Often, the parties can allay any concerns regarding the effects of discounts by placing a maximum discount percentage that can be deducted revenue for purposes of calculating the royalty and/or by ensuring that, for purposes of the royalty calculation, any discount to the royalty-bearing portion of fees will not be disproportionate to the discount to any excluded revenues (e.g., non-recurring implementation or training services as referenced above).
This post is part of our recurring “Contract Corner” series, which provides analysis of specific contract terms and clauses that may raise particular issues or problems. Check out our prior Contract Corner posts for more on contracts, and be on the lookout for future posts in the series.