Royalties: What they are, how payments work in business

Published Wednesday 22 April 2026

Table of contents

• What are royalties?
• Types of royalty payments
• Examples of royalties in small business
• Understanding royalty agreements
• Common royalty mistakes to avoid
• Factors affecting royalty rates
• How royalty payments work in practice
• FAQs on royalties

Key takeaways

• Recognize that royalties come in three main forms—franchise royalties, intellectual property royalties, and licensing royalties for creative works—so you can identify which type applies to your business assets or usage needs.
• Always define payment terms clearly in your royalty agreement, specifying whether payments are based on gross or net sales, and include an audit clause so you can verify the amounts you receive are correct.
• Get a lawyer to review any royalty contract before you sign, whether you are the licensor or licensee, to make sure your rights, payment terms, and termination conditions are fully protected.
• Account for tax obligations from the start, as royalty income is taxable and payments to non-residents may require you to withhold and remit tax to the CRA—failing to do so can result in a penalty of 10% of the required tax amount.

What are royalties?

Royalties are payments made to asset owners for the right to use their property, which can include intellectual assets, physical real estate, or even timber royalties. The owner who receives payment is called the licensor, while the party paying for usage rights is the licensee.

These payments typically take two forms: a percentage of revenue or a fixed fee per unit sold. This arrangement is common in industries like music, technology, and franchising where intangible assets drive business value.

Royalty agreements are most common in industries built on intangible assets:

• Music and entertainment: digital files, streaming rights, and performance licenses
• Publishing: books, articles, and written content
• Technology: patents, software, and proprietary systems
• Franchising: brand identity, business models, and operational systems

Types of royalty payments

Royalty payments fall into three main categories based on the asset type and business model: franchise royalties, intellectual property royalties, and licensing royalties for creative works.

Franchise royalties

Franchise royalties are payments franchisees make to the franchisor for the right to use their business model, branding, intellectual property, and operational systems. The franchise model is popular in fast food, with 93% of McDonald's restaurants operating as franchises.

Franchisees usually pay royalties as a percentage of gross or net revenue, although some agreements use flat fees.

Learn more about franchises in our guide.

Intellectual property royalties

Intellectual property royalties are payments licensees make for the right to use or sell protected assets like patents, trademarks, and copyrighted works. These royalties are common in tech and manufacturing, while copyright royalties appear frequently in publishing, music, and film.

Specific tax rules often apply, such as Canada's standard 25% withholding tax rate on non-resident payments. For example, Canadian tax law requires withholding tax on payments to non-residents for the use of a motion picture film or videotape for television.

Examples include a tech company licensing patented software or an author licensing their work to a publisher.

Licensing royalties for creative works

Licensing royalties for creative works apply to music, films, artwork, writing, and other creative mediums. Instead of selling the work directly, businesses pay licensing fees to use these works in a different context.

Common uses include advertising, entertainment, and product design. Examples include a song licensed for a TV ad or a publisher licensing illustrations for a children's book.

Examples of royalties in small business

Here are a few ways small businesses use royalty agreements every day:

• Retail and merchandising: a local clothing brand pays a royalty to an independent artist to print their illustrations on t-shirts
• Software and apps: a tech startup licenses a specialized piece of code from another developer, paying a small fee for every user who downloads their app
• Manufacturing: a small manufacturer produces a patented kitchen gadget and pays the original inventor a percentage of each sale

Understanding royalty agreements

Royalty agreements are legally binding contracts between licensors and licensees. The terms must be clear, transparent, and enforceable so both parties understand their obligations and what happens if terms aren't met.

Before signing, each party should focus on different priorities:

• for licensors: ensure your rights, payment terms, and protections are clearly outlined and enforceable
• for licensees: verify the contract accurately reflects your intended use and complies with applicable laws

Get legal advice

Both parties should ask a lawyer to review the contract before signing.

• For the licensee: ensure the contract complies with legal requirements and accurately reflects the terms of the specific arrangement
• For the licensor: understand each clause fully and ensure the agreement clearly outlines your rights, payments, and protections

Common royalty mistakes to avoid

Keep an eye out for these common pitfalls:

• vague payment terms: always define exactly what revenue means in your contract. Specify whether royalties are based on gross sales or net sales to avoid confusion later
• forgetting about taxes: remember that royalty payments are taxable. Failing to account for withholding tax on international payments can leave you with unexpected bills, as the CRA can assess a penalty of 10% on the required tax amount you failed to deduct
• skipping the audit clause: without the right to audit the licensee's records, you have no way to verify that you are being paid the correct amount
• ignoring termination conditions: make sure your agreement outlines exactly how and when either party can end the relationship

Factors affecting royalty rates

Royalty rates vary based on market conditions and contract terms. Five key factors determine what you'll pay or receive:

• industry standards: established rate ranges within specific sectors
• asset value: higher-value assets command higher royalty rates
• negotiating power: well-known creators and strong distributors secure better terms
• exclusivity: exclusive rights typically cost more than shared licensing
• market demand: popular or anticipated assets generate premium rates

Learn more about real-world royalty rates.

How royalty payments work in practice

The royalty payment process follows six steps from initial agreement to ongoing compliance.

1. Establish a royalty agreement

A royalty arrangement starts with the licensor and licensee negotiating and drafting a formal licensing agreement. A strong contract should outline the asset being licensed, how it can be used, and the structure of the royalty payments.

Contract negotiation strategies help you secure favourable terms and protect your interests:

• include performance-based termination clauses: protect yourself from underperforming arrangements by setting clear revenue expectations
• define geographic and usage scope: specify exactly where and how the rights apply to avoid future disputes
• negotiate exclusivity terms: weigh the higher cost of exclusive rights against preventing competitor access
• set appropriate contract duration: balance stability with flexibility to renegotiate as markets change

2. Define the payment terms

Payment structure determines how much you'll pay or receive and when those payments occur. Choose the structure that best aligns with your business model and cash flow needs.

Three main royalty structures exist:

• percentage of revenue: fixed percentage of sales, such as 5% of net sales for franchisees
• fixed fee per unit: set amount per item sold, such as $5 per ebook copy
• usage-based payments: fees tied to actual usage, such as per-stream payments for music

Tip for licensors: Look beyond the payment amount. Consider how often you'll receive royalties and how long you'll wait each payment cycle, as both affect your cash flow.

3. Track your usage or sales

Tracking and reporting is the licensee's responsibility. They record how much revenue the asset generates and report to the licensor on a schedule set by the contract, such as monthly or quarterly.

4. Calculate your payments

Calculating payments involves applying the agreed payment structure to tracked sales or usage data. Several factors can affect the final amount:

• minimum guarantees: set amount the licensor receives regardless of performance
• advances:payments made upfront and recouped from future royalties
• deductions: adjustments for returns and refunds
• escalators: higher royalty rates that apply after reaching certain sales or revenue thresholds

5. Make payments

Making payments happens according to the agreed schedule. The licensee may issue a royalty statement or request that the licensor raises an invoice to document the transaction.

For international payments, any tax withheld must also be remitted to the proper authorities. In Canada, non-resident tax deductions must be received by the Canada Revenue Agency (CRA) on or before the 15th of the following month to avoid a penalty for remitting late of up to 10%.

Use one of Xero's free invoice templates.

6. Auditing and compliance

Auditing and compliance ensures both parties meet their contractual obligations. Regular audits verify that reported sales match actual performance and that payments are calculated correctly.

Most agreements include audit rights that allow the licensor to review the licensee's financial records. This protects licensors from underpayment and helps licensees demonstrate they're meeting their obligations.

FAQs on royalties

Here are answers to common questions about royalty payments and agreements.

What is a typical royalty rate?

Royalty rates vary widely by industry. Franchise royalties typically range from 4% to 8% of gross revenue. Technology and patent royalties often fall between 0.5% and 5% of net sales. Music streaming pays fractions of a cent per stream, while book publishing typically pays authors 10% to 15% of the retail price.

How often are royalties paid?

Payment frequency depends on your contract terms. Most agreements specify monthly or quarterly payments, though some annual arrangements exist. The contract should also define when each payment is due, such as 30 days after the end of each reporting period.

Do you pay tax on royalty income?

Yes, royalty income is taxable. In Canada, if you receive royalties, you report them as business income on your tax return. If you pay royalties to non-residents, you may need to withhold tax at a rate of 25% (or lower if a tax treaty applies) and remit it to the CRA.

Can you negotiate royalty rates?

Yes, royalty rates are negotiable. Factors that strengthen your negotiating position include the value of the asset, your track record, market demand, exclusivity terms, and comparable rates in your industry. Both parties should research industry standards before entering negotiations.

What happens if someone doesn't pay royalties?

If a licensee fails to pay royalties, the licensor can take several actions. Most agreements include late payment penalties and termination clauses. The licensor may suspend the licensee's rights to use the asset, demand immediate payment of all outstanding amounts, or pursue legal action to recover unpaid royalties and damages.