Royalties: How they Work | Attorney Aaron Hall

Royalties: How they Work

Introduction

If your business works in the entertainment industry, the oil and gas industry, or certain other industries, you may become a party to a contract involving royalties. This article highlights what they are and how they work.

When a person creates a book, song, play, or painting, the creator generally owns the intellectual property rights (unless an agreement has been signed to transfer the rights). Similarly, when an inventor receives a patent on an invention, the inventor has intellectual property rights.

Examples

For example, a singer who records an album might get a royalty of 15 percent from CD sales. Actors starring in a television show might get a royalty from merchandising products sold with their images on them. But today’s royalty calculations and contracts can be much more complex as these two cases illustrate.When a business obtains the right to market the creation of another business, the creator (and in some cases, other individuals involved) usually receive compensation in the form of a royalty.

Facts of case number 1:

In 1995, F.B.T. Productions LLC signed the rap artist known as Eminem, gaining exclusive rights to his recordings. F.B.T. signed an agreement transferring the recordings to Aftermath Records. Provisions of the contract provided for different percentages of royalties — 12 to 20 percent for “records sold” (such as a CD) and 50 percent on “licensed music” (such as songs used in a television commercial).

The production company filed a lawsuit arguing that it should receive 50 percent of royalties from “permanent digital downloads” of Eminem recordings. The producers claimed that the record label should treat these downloads (from stores such as Apple’s iTunes) and sales of cell phone ringtones as licensed music, which received the higher royalties.

A jury verdict ruled for Aftermath Records. However, an appeal, the U.S. Ninth Circuit ruled that F.B.T. Productions was owed a 50 percent royalty on the permanent downloads, ringtones and other third-party uses. The case was remanded for further proceedings on the damages. In October of 2012, the producers and the parties settled the case but the terms of the agreement were not revealed. (F.B.T. Productions LLC v. Aftermath Records, Nos. 09-55817, 09-56069, U.S. Ct. of App, 9th Cir.)

Facts of case number 2:

The television show Happy Days, which ran from 1974 to 1984, has remained popular decades later. Episodes are available for purchase on DVDs and merchandise, including t-shirts, games and lunch boxes, has also been sold.

Some of the actors claimed they did not receive royalty money owed to them as a result of the sale of show-related items with their images on them.

A lawsuit was filed in April of 2011 after the actors discovered a Happy Days slot machine at a casino in Las Vegas. Some, but not all, of the regular actors in the sitcom joined forces in the suit and sought $10 million in unpaid merchandising royalties.

According to the lawsuit, the actors signed contracts giving them between 2.5 percent and 5 percent of net proceeds from items with their images on them. The suit was filed against CBS Studios Inc. and Paramount Pictures, which had a division that produced the sitcom.

Shortly before the trial was scheduled to begin in July of 2012, the case was settled. Although the exact terms were not revealed, the plaintiffs’ attorney announced that each actor received payment and an agreement that the original contract terms would be honored on future sales. (Anson Williams et al v. CBS Studios et al, Superior Court of the State of California, No. BC459841)

Contract Provisions Are Critical

Today’s recording and actor contracts would almost certainly include provisions about digital downloads, ringtones, DVD sales and merchandising. But as the F.B.T. Productions and Happy Days cases illustrate, when parties are signing a contract, they can’t imagine what future issues and technologies might involve. That is why written agreements are so critical.

Here are some basics about royalties and the related contract provisions:

  • Royalties are payments for the use of an asset through a license agreement.
  • In most cases, the asset is intellectual property.
  • The party that owns the assets is the licensor and the person or entity using the assets is the licensee.
  • The use of the asset can be for one time only, and at other times, it is for the use of the asset on an ongoing basis.
  • Royalty payments are usually a percent of the gross or net revenue derived from the use of the asset. Alternatively, a royalty payment could be a fixed price per unit sold or a variation thereof.
  • A person entitled to collect the stream of future royalty payments has a “royalty interest.” For example, in the oil and gas industry, a royalty interest could be defined as a percentage ownership in the future production of revenue, which could even be divested from the original owner of the asset.
  • As a set percentage of gross revenue, royalties may accrue regardless of profit, or the revenue of the operator. In other words, current royalties could accrue regardless of risk and liability that may lie with the licensee or operator of the business.
  • An important royalty contract provision involves the ability of the licensor to audit the licensee to ensure all royalty payments are being made.

Some of the different types of royalties involve:

  • Patents;
  • Trademarks;
  • Copyrights;
  • Book publishing;
  • Music;
  • Art;
  • Oil and Gas; and
  • Software

One of the major issues is how to value royalties or how to derive the royalty percentage or rate. Generally, there are three approaches to determine the applicable royalty rate in the licensing of intellectual property. They are:

  1. The cost approach;
  2. The comparable market approach; and
  3. The income approach.

Even when determining a royalty rate using the various approaches, it is always best to have a legal adviser who knows the standard for your industry.

In a fair evaluation of the royalty rate, the relationship of the parties to the contract should:

  • Be at “arms-length” (related parties such as the subsidiary and the parent company need to enter the transaction as though they were independent parties).
  • Be viewed as acting free and without compulsion.