by Attorney Richard Stim

For artists who have successfully licensed their works, royalty payments can provide welcome additional income. Be sure to understand how your royalties are calculated.

Whether you license a painting or jewelry, the benefits are the same. You retain legal ownership of the work -- for example, you keep your copyright or design patent -- while someone else makes and sells your item (or duplicates your imagery on merchandise). In return for granting the license, you receive a royalty, a continuing payment based upon a percentage of the income from the licensed artwork. Imagine if, instead of laboring in your studio all day, you waited by the mailbox for royalty checks.

Understanding Licensing Lingo

The key to negotiating payments in a licensing deal is to understand the terminology. Below are some definitions.

Advance against royalties. An advance is an up-front payment to you, usually made at the time the license agreement is signed. An advance is almost always credited or "recouped" against future royalties, unless the agreement provides otherwise. It's as if the licensee is saying, "I expect you will earn at least $1,000 in royalties so I am going to advance you that sum at the time I sign the agreement." When you start earning royalties, the licensee (the company who licensed the artwork from the artist) keeps the first $1,000 to repay the advance to itself. If the artist doesn't earn the $1,000 in royalties, the licensee takes a loss. You don't have to return the advance unless you breach the agreement. On rare occasions, a licensee may pay you a "one-time license fee" at the time of signing the agreement. This fee differs from an advance because it is not deducted from royalties.

Gross sales. "Gross sales" refers to the total amount billed to customers who buy the product containing the licensed artwork. "Net sales" are usually defined as the licensee's gross sales minus certain deductions. In other words, the licensee calculates the total amount billed to customers and deducts certain items, such as the costs of goods, before calculating and paying the royalty.

Deductions. Deductions are items deducted from sales before the royalty is calculated. In general, it is acceptable for a licensee to deduct from gross sales any amounts paid for taxes, credits, returns, and quantity discounts made at the time of sale. It is also not unusual for a licensee to deduct shipping (the cost of getting the products to the buyer).

Deductions are as important as the royalty rate in determining how much money ultimately comes your way. For example, a royalty rate of 2% of net sales with no deductions may earn you more than you'd get from a 5% royalty rate from which various licensee expenses are deducted.

If possible, avoid deductions for bad debts and uncollectible accounts (that is, a third party orders products and then fails to pay), for sales commissions (a salesperson is paid a commission for each sale of the licensed product), for fees (a vague term that includes a wide range of licensee costs and business expenses), or for promotion, marketing, or advertising costs (these are costs of the licensee's business, not yours). If it's difficult to negotiate individual deductions with a licensee, consider setting a fixed percentage for deductions, say 10%.

Computing Royalties

Royalty payments are computed by multiplying the royalty rate against net sales. For example, a royalty rate of 5% multiplied by net sales of $1,000 equals a net sales royalty of $50. Royalty rates for licensing vary depending on the artwork involved. Below are some royalty estimates:

• Greeting cards and gift wrap: 2% to 5%
• Household items such as cups, sheets, towels: 3% to 8%
• Fabrics, apparel (T-shirts, caps, decals): 2% to 10%
• Posters and prints: 10% or more
• Toys and dolls: 3% to 8%

In some cases, an artists may negotiate a "per unit royalty" that is tied to the number of units sold or manufactured, not to the total money earned by sales. For example, under a per unit royalty you might receive $.50 for each licensed product sold or manufactured.

Demanding a Guaranteed Minimum

If the licensee is very excited about your artwork and wants a long license, you may want to consider a "guaranteed minimum annual royalty payment" (GMAR). With a GMAR, the licensee promises to pay you a specific amount, usually at the beginning of every year, regardless of how well the merchandise sells during the year. At the end of that year, if the earned royalties exceed the GMAR, you're paid the difference. If the GMAR exceeds the earned royalties (you were paid more than the product earned), the licensee usually takes a loss (unless the licensee has negotiated to apply the difference to future GMARs).

Auditing Royalties

You'll want the right to perform an audit to detect and quantify a possible shortfall in your royalty payments. In your agreement, you should include an audit provision that describes when you (or your representative) can access licensee records, and that if the audit uncovers an error of a certain magnitude -- commonly a sum between $500 to $2,000 -- the licensee will not only have to compensate you for the shortfall, but for the costs of the audit as well. You should also ask for an attorney fees provision in your licensing agreement so that in the event you must sue the licensee for royalties or audit costs, a court judgment would include your legal fees.