What are royalties? Definition, types and how they work

Published Friday 13 February 2026

Table of contents

• Business royalties: a definition
• How royalties work
• Types of royalty payments
• Examples of royalties
• Factors affecting royalty rates
• How royalty payments work
• Understanding royalty agreements
• Tax implications of royalties for business
• Simplify royalty payments and business finances with Xero
• FAQs on royalties

Key takeaways

• Negotiate clear royalty agreements that specify payment structure, usage rights, geographic scope, and termination clauses to protect your interests whether you're paying or receiving royalties.
• Calculate royalty payments using the agreed method: multiply percentage rates by revenue, fixed fees by units sold, or usage-based fees by number of uses, while accounting for any deductions or minimum guarantees.
• Track and document all royalty-related transactions meticulously, as licensees must report usage data accurately and both parties need detailed records for tax compliance and potential audits.
• Consider international tax implications early, including withholding tax requirements and double taxation agreements, and consult tax professionals when dealing with cross-border royalty arrangements.

Business royalties: a definition

Royalties are payments made to an asset owner for the right to use their property. These payments are typically calculated as a percentage of revenue or a fixed fee per unit sold.

The licensor owns the asset and receives royalty payments. The licensee pays for permission to use it.

Royalty agreements are common in industries where products are intangible, including:

• music and entertainment
• publishing
• technology and software

How royalties work

Royalties work through a licensing agreement between an asset owner (licensor) and a business or individual who wants to use that asset (licensee).

Here's how the process typically unfolds:

1. Negotiation: Both parties agree on terms including the royalty rate, payment schedule, and usage rights
2. Agreement: Both parties sign a formal contract outlining all terms and conditions
3. Usage: The licensee uses the asset according to the agreed terms
4. Tracking: The licensee records sales or usage data related to the asset
5. Payment: The licensee pays royalties to the licensor on the agreed schedule

The licensor earns ongoing income without selling the asset outright. The licensee gains access to valuable assets without the cost of creating them.

Types of royalty payments

Royalties come in different forms, depending on the nature of the asset and the business model. Here are three common types.

Franchise royalties

Franchise royalties are payments franchisees make to use a franchisor's business model, branding, and operational systems.

Most franchisees pay royalties as a percentage of gross or net revenue, though some agreements use flat fees. The franchise model is common in fast food. For example, franchisees run about 95% of McDonald's U.S. restaurants.

Learn more about franchises

Intellectual property royalties

Intellectual property (IP) royalties are payments for the right to use or sell protected assets. These include:

• Patents: Common in tech and manufacturing
• Trademarks: Used for brand licensing
• Copyrights: Frequent in publishing, music, and film

For example, a tech company might license patented software, or an author might license their work to a publisher in exchange for royalties.

Licensing royalties for creative works

Licensing royalties for creative works let businesses use music, films, artwork, or writing in new contexts without buying the work outright.

Common uses include:

• licensing a song for a TV advertisement
• using illustrations in a children's book
• featuring artwork in product packaging

Examples of royalties

Here are real-world examples of how royalties work across different industries:

• Franchise example: A coffee shop franchisee pays 6% of monthly revenue to the franchisor for the right to use their brand, recipes, and business systems
• Music example: A streaming platform pays a songwriter £0.003 each time their song is played
• Publishing example: An author receives 10% of the cover price for each book sold through their publisher
• Technology example: A smartphone manufacturer pays a patent holder £2 per device for using their wireless charging technology
• Brand licensing example: A clothing company pays 8% of sales to use a sports team's logo on merchandise

In each case, the asset owner earns ongoing income while the licensee gains access to valuable intellectual property.

Factors affecting royalty rates

Several factors influence how much licensors can charge. Here are the key considerations:

• Industry standards: Vary by sector, with music and publishing following recognised ranges. Research shows that reported royalty rates can represent anywhere from 15% of gross margins to 53% of EBIT margins, depending on the industry.
• Asset value: High-value assets typically command higher rates
• Negotiating power: Well-known creators often secure better terms, while licensees with strong distribution gain leverage
• Exclusivity: Licensees may pay premiums for exclusive rights or non-compete clauses
• Market demand: Anticipated or trending assets can fetch higher rates

Once you understand what affects rates, you can calculate your payments.

How to calculate royalty payments

Calculating royalties depends on the payment structure in your agreement. Here are the common methods:

Percentage of revenue

Multiply the agreed royalty rate by the relevant revenue figure.

Example: If your royalty rate is 5% and the licensee generates £10,000 in sales, your royalty payment is £500 (£10,000 × 0.05).

Fixed fee per unit

Multiply the per-unit fee by the number of units sold.

Example: If you earn £2 per unit and the licensee sells 1,000 units, your royalty payment is £2,000.

Usage-based

Multiply the per-use fee by the number of uses.

Example: If you earn £0.01 per stream and your song is streamed 100,000 times, your royalty payment is £1,000.

Always check your agreement for any deductions, minimum guarantees, or escalators that may affect the final amount.

Learn more about real-world royalty rates

How royalty payments work

Understanding the royalty payment cycle helps you manage agreements confidently, whether you're paying or receiving royalties. Here's how a typical arrangement works in practice.

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, permitted uses, and the royalty payment structure.

Here are strategies for negotiating a stronger contract:

• Include a performance-based termination clause: Protect yourself if the asset doesn't generate expected revenue
• Specify geographic and usage scope: Define the countries, regions, and domains (online or offline) where rights apply
• Clarify exclusivity terms: If the licensee wants exclusive rights, the licensor can negotiate better rates
• Set a clear duration: Longer deals offer stability, while shorter terms let licensors renegotiate sooner

2. Define the payment terms

Set out exactly how royalty payments will work. Royalty structures typically fall into three categories:

• Percentage of revenue: A fast-food franchisee might pay 5% of net sales to the franchisor
• Fixed fee per unit: An author might receive £5 for every ebook sold
• Usage-based: A band earns royalties each time their song is streamed

If you're the licensor, consider payment frequency and timing alongside the rate, as both affect your cash flow.

3. Track your usage or sales

The licensee is responsible for tracking and reporting royalty-related revenue, as accounting standards require entities to recognise revenue from royalties only after a subsequent sale or usage occurs.

This includes recording how much revenue the asset generates and reporting to the licensor on the schedule set in the contract (typically monthly or quarterly).

Accurate reporting builds trust and strengthens the working relationship between both parties.

4. Calculate your payments

Next, the licensee calculates what's owed based on the payment structure and agreed terms.

Several factors can affect the final amount:

• Minimum guarantees: A set amount paid to the licensor regardless of performance
• Advances: Upfront payments recouped from future royalties
• Deductions: Adjustments for returns and refunds
• Escalators: Higher rates that apply after reaching sales or revenue thresholds

5. Make payments

Finally, the licensee makes the payment according to the agreed schedule. To document the transaction, the licensee may issue a royalty statement or request that the licensor raise an invoice for the payment amount.

Use one of Xero's free invoice templates

6. Auditing and compliance

Most royalty agreements give the licensor the right to audit the licensee's records, either on request or at regular intervals. This protects the licensor by verifying that payments match the agreed terms.

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 the consequences of non-compliance.

Whichever side of the arrangement you're on, invest time upfront to get the agreement right.

Get legal advice

Both parties should have a lawyer review the contract before signing.

• Licensees (typically drafting the agreement): Ensure the contract is legally compliant and accurately reflects the negotiated terms
• Licensors: Verify that each clause protects your rights, payments, and interests

Tax implications of royalties for business

Royalties have tax implications for both parties in a licensing agreement.

• If you receive royalties: You typically need to report them as taxable income
• If you pay royalties: They're usually tax deductible as a business expense

Account for royalties properly and reflect them in your tax returns.

International tax considerations

International royalty agreements involve two additional tax considerations: withholding tax and double tax agreements.

Withholding tax for licensees

When paying royalties internationally, you may need to withhold a portion and send it to your local tax authority. For example, a US company paying royalties to a UK rights holder may need to withhold a portion for the IRS. Under US domestic tax law, the US generally taxes foreign persons at 30% on the gross amount of certain US-source income, meaning the licensor would receive only 70%.

Double tax agreements for licensors

Without protection, licensors can be taxed twice: once through withholding and again in their home country. Double tax agreements between countries can reduce or eliminate this.

Under the UK–US Double Taxation Convention, UK licensors can receive 100% of royalties before domestic tax applies. To qualify, provide the required paperwork, such as a certificate of residence and Form W-8BEN.

Tips to stay compliant

Follow these tips to stay compliant and maximise your royalty arrangement:

• Keep detailed records: Document all payments, dates, and signed agreements for audit purposes
• Consider tax implications early: Factor taxes into rate negotiations and payment terms
• Consult a tax professional: Seek expert advice when licensing across borders or dealing with unfamiliar jurisdictions

Learn more about withholding tax and other tax deductions.

Simplify royalty payments and business finances with Xero

Whether you're paying or receiving royalties, you can stay organised with Xero. Track invoices, monitor payments, and keep clear records for tax time, all in one place.

Get one month free and see how Xero simplifies royalty management for small businesses.

FAQs on royalties

Here are answers to common questions about royalties for small businesses.

What is an example of a royalty?

A royalty example is when a franchisee pays 5% of their monthly revenue to the franchisor for the right to use their brand and business model. Another example is an author receiving £1 for each book sold through their publisher.

How do I calculate royalty payments?

Multiply the royalty rate by the relevant figure (revenue, units sold, or usage count). For example, a 10% royalty on £5,000 in sales equals £500.

Do I need a lawyer for a royalty agreement?

Yes, both parties should have a lawyer review the contract. Licensees need to ensure legal compliance, while licensors should verify their rights and payment terms are protected.

How are royalties different from commissions or fees?

Royalties are ongoing payments for using an asset over time. Commissions are one-time payments for completing a sale or transaction. Fees are typically flat charges for a specific service.

What's a typical royalty rate for my industry?

Royalty rates vary by industry. Franchise royalties typically range from 4% to 12% of revenue. For example, McDonald's announced it was raising those fees for new restaurants from 4% to 5%. Publishing royalties often fall between 5% and 15% of sales. Music streaming royalties are usually fractions of a penny per play.

Published Sunday 25 August 2025