The royalty rate is the price a licensing partner is willing to pay for your intellectual property rights. Structuring how it’s calculated is just as important as determining the royalty rate amount. The more critical or significant your IP is to revenue and profitability, the higher the royalty rate. But that’s not the only determining factor. Many things affect royalty rates including:
- How unique is your IP (i.e. the scarcity of alternatives)
- The cost of using similar IP’s
- Cost savings of licensing it vs. not using it or developing it internally
- The synergies of combining your IP with other IP’s
- How profitable it is to use
- The competitive advantage your IP offers
Value is what licensing partners are looking for. IP that does something better, in a different way, at a lower cost, and/or more effectively. In some situations, such as joint ventures, a valuation is important especially if the intellectual property is jointly owned. A valuation helps reduce risk for potential investors by demonstrating why an IP offers a direct path to rapid revenues. Other reasons you’ll need to know the value of your intellectual property include:
- Buying or selling a business
- For bankruptcy proceedings
- As security for debt finance
- Negotiating a licensing deal
In this article, we’ll review the different ways of calculating royalty rates, the 3 most common ways to value IP – Market, Cost and Income – and how to use them to negotiate and structure the best royalty rate terms for your licensing deal.
While there are many ways to structure royalty payments, here is a quick summary of some of the most common ones. Many licensing deals often combine these structures.
- Lump Sum: A single payment, usually paid one time or annually, and it’s generally not tied to any sales or performance benchmarks. It’s often used with unknown technologies, when sales are hard to project or in mature markets where the profit margins are very low.
- Minimum Royalty or Guarantee: This is a minimum amount of royalties to be paid regardless of sales. The payments are usually spread over time, such as quarterly. It’s often combined with a fixed percentage model (see below), and royalties are paid before actually earning them through sales (this is known as an advance against future royalties). Minimum guarantee payments are usually recouped by the licensee before paying any more royalties. For example, if $100,000 is paid when the agreement is signed, and the royalty rate is 10%, this “pre-pays” royalties for the first one million dollars in sales. It’s used in licensing deals where there are big mature product markets with lots of customers and distribution (e.g. entertainment and brands), and emerging technologies (e.g. biotechnology, robotics, etc.) where upside revenues can be significant.
- Fixed Percentage: One of the most common structures, it’s also known as a running royalty paid on a per sale or per unit basis. It’s fixed over time ( i.e. 3%) and usually combined with a minimum guarantee royalty. The royalty is tied to sales and calculated on the selling price (net or some variation) of the product or technology.
- Tiered or Volume Percentage: A variable royalty rate moves up or down based on the sales or revenue volume of the licensee. For example, the royalty starts at 3% for sales revenue between 0 and $2 million, then increases by 1% at $2 million, and tops out at 5% for sales over $5 million. This formula is best for a new technology or product that requires a lot of time and money to get it into the market, and the profit margins are unknown, such as launching in a foreign market.
If you’re the IP owner, the valuation helps you figure the highest royalty rate and the best way to structure it in your licensing agreement. If you’re the licensee, it helps you avoid overpaying for an unknown or unproven IP. These approaches are not mutually exclusive. In many cases, especially if it’s an unproven technology, two approaches are often combined to help calculate the royalty rate.
- Market Approach: Market based valuations analyze comparable royalty rates and minimum guarantees for licensing. It’s often used to value established brands, where detailed information about comparable brand licensing programs is available from various sources, such as licensing trade magazines and public company filings. These types of licensing programs are comparable in licensing terms such as duration, royalty rates, product categories and territories. For example, you’ve built a leading cosmetic brand in the US with national distribution and you’re considering licensing it internationally. It’s well known outside the US and there are no close competitors. In this situation, the valuation might include comparable premium licensed brands in Europe or South America to determine the highest royalty rate for an exclusive license.
- Cost Approach: The cost approach is often used with complex patents, and unproven or new technologies and processes with no revenue track record and no comparable data, such as software and trade secrets. Cost based valuations help decide whether it’s more cost-effective to develop/re-create an IP or license-in rights to it. For example, if your patent is a market-ready product, it will generate an immediate revenue stream (either operating income or licensing income). This is compared to developing the IP. In this case, it’s estimated to take two years to develop, which in effect is “losing” two years of profit. The difference is the incentive to license it. If there’s comparable market data, this method is combined with either the income or market method to determine the royalty rate. If the technology is something completely new in an emerging market, such as a new gene therapy for muscle disorders, and there is no comparable market data, determining the royalty is much trickier. In this case, it comes down to market potential and which royalty payment structures make the most sense.
- Income Approach: This method is used for patented products or technologies in mature industries with revenue track records, such as pharmaceuticals, IT and electronics. The royalty rate is calculated based on how much profit margin the IP contributes to revenue. For example, if the industry average profit margin is 15% and the patented technology accounts for 50% – 60% of the product, then the royalty rate would be about 3.5% – 4%. It’s then checked against comparable rates for similar types of technologies or products. It gives you a stronger negotiating position based on market research and data.
The biggest motivator for a company to license your intellectual property is the financial return it offers them. If your IP is ready to go, the valuation proves why its a faster return than building it from scratch. If your IP is a complex technology, expensive to develop, or in a highly competitive market, a valuation shows why licensing is a lower risk financial strategy with a higher return. Of course, in licensing a big part of determining the royalty rate is negotiation. It often comes down to what someone is willing to pay for the rights to use your IP.