Standard royalty rates? Ain’t no such thing.

what's it worthFor the inexperienced businessman, it is the most natural question in the world.  How much, he asks his advisers, should I be charging for this IP licence?  His opposite number, the inexperienced licensee, may similarly want to know: how much should I pay for this licence?  Unfortunately, there is rarely a simple (and unarguably true) answer to this question.

If you sell cabbages in a street market, it is important to know the market price of your goods. Sell at too high a price, and you are left with perishable stock at the end of the day.  Sell at too low a price, and you may be able to go home early, but you haven’t maximised your profits.  You can go round the other stalls and see what price is being charged there.  You can compare your prices with those in the local supermarket.  You can remember what price you charged last week, and use this as a base point for making price adjustments.

How do you make a sauer kraut?

How do you make a sauer kraut?

You can also think about how much you had to pay, and what mark-up you need to make a profit.  This doesn’t really affect the market price, but it may help you decide whether it is worthwhile selling cabbages.  It may also give you an insight into what other cabbage retailers are likely to be paying.

It’s not just the price that affects sales, although this is a major element.  It makes a difference how good you are at enticing customers to your stall, through good choice of location, an attractive display, and a persuasive line in cheeky banter.

So why isn’t there an equivalent for IP licensing, the businessman may ask.  Why isn’t there a simple way of working out how much a licence is worth, particularly in relation to upfront payments and royalties?

Well, for one thing, IP is usually a much more complex commodity than cabbages.  IP tends not to have as clear a market value as cabbages.  Factors that affect value, and which are not always predictable, include the strength of patent claims and other IP, how much of a competitive advantage the IP brings, the size and profitability of the markets for products that are protected by the IP (and whether those products can be brought to market), how the IP will be used (eg to improve products, offensively to prevent competition, or defensively as a bargaining chip in pooling arrangements), how rich and determined are other parties that may wish to challenge the IP, and so on.

Tmoney money moneyhere are exceptions.  The IP in the Beatles’ back catalogue has a sufficient track record to make forward income streams predictable. IP that is sold in auction may have established a market value, but will that value hold over time?

One area of complexity is the structure of payments in licensing agreements.  In the biotech sector, a typical structure is an upfront payment, additional payments on achievement of development milestones, and royalties.  The amounts paid can vary widely.  In one biotech licensing transaction in which IP Draughts was involved, many years ago, there was an upfront fee of $11.5M, payments on achievement of development milestones, totalling $27M, “windfall” fees on large sales of up to $10M, and tiered royalties between 9% and 13% of net sales.  The product didn’t make it to market.

Milestone payments are less commonly seen in other industry sectors.  With some enabling technology, much smaller royalties are seen, sometimes less than 1% of net sales.  In some industry sectors, licensees refuse to pay any royalty, citing the large number of licensing deals they do in respect of each product, which would make it impractical (it is said) to pay royalties.  Instead, a lump sum is paid.

Once a payment structure is established (eg upfront payments, milestones and/or royalties on sales), the amounts to be paid in each of these categories need to be decided.  Different methods are used to work out how much to charge in licensing agreements.  The main methods can be summarised as:

  1. Look at how much it has cost to generate the IP.  This is usually a terriblecost plus method, although sometimes it may help to benchmark the cost to the licensee of generating similar IP, if he chose to do so.  Typically, though, the licensee doesn’t care how much the IP cost to generate, he cares how much he can earn from it.
  2. Look at similar deals to establish a market price or “going rate”.  This is a better method, but it may not be easy to find the data on comparable deals.  Parties tend to keep this information to themselves, for example by redacting it from the agreements that they lodge with the US Securities and Exchange Commission, which end up on the EDGAR website.  market stallExperienced licensing managers know what financial terms they managed to achieve on previous deals.  Beginners don’t have this knowledge.  Some publications provide data on past deals, eg the Licensing Executive Society publishes the results of surveys of its members.  This data may be of only limited value unless it is very specific to the deal under discussion.  To continue the cabbage analogy, some of the data is analogous to the average sale price of vegetables in Europe in the last decade.  If you are lucky, it may be broken down to the sale of green vegetables in England across all retail outlets in the last year.   If you are very lucky indeed, you may get data on the price paid on Friday afternoons for organic cabbages in Bolton market in the last 3 months.  But even this level of detail doesn’t tell you what customers will pay in the next 3 months.  So, the information has value but often doesn’t tell you the “correct” price to charge for licensing a specific package of IP.
  3. financial advisorPay a consultant to tell you what the correct price is.  There are some financial consultants who specialise in licensing valuations.  IP Draughts would need to be very convinced about the quality of the consultant and the quality of his data before spending money on such a service.
  4. Use some “rule of thumb” methods that are mentioned in textbooks and other publications, eg some introductory guides produced by the UK Intellectual Property Office, mentioned recently on IPKat here.  For 25%example, if you know what the licensee’s gross profits will be on the sale of licensed products, the “25% rule” suggests that the licence payments should be equivalent to 25% of these profits.  In IP Draughts’ view, this might be useful as a secondary “sanity check” on any proposed terms, but should probably not be used a primary valuation method.  Less useful, in IP Draughts’ view is the suggestion in some of these materials that a royalty in the region of 5% of net sales should be charged, in view of the wide variance of royalty rates that IP Drafts has seen.

In practice, licensing managers may use a combination of items 1, 2 and 4 above, and may take informal soundings from colleagues to obtain a free version of item 3.

However the financial terms are arrived at, be clear on what any royalty rate is based on.  On more than one occasion, a commercial client has presented IP Draughts with a term sheet that has a cryptic reference to, say, “a royalty of 7%”.  In a secure storage facility, deep in the vaults of IP Draughts’ castle, there is a recording of the subsequent conversation that IP Draughts had with his client…

IP Draughts: this 7% figure, what is it based on?

Client: It’s a 7% royalty on sales.

IP Draughts: We discussed that the licensee is unlikely to sell products itself, but will be sub-licensing.  Is it 7% of the sub-licensee’s sales price, or 7% of what the licensee gets in royalties from the sub-licensee?

Client: Don’t know, we didn’t discuss that, what do you think it should be?

[At this point, a loud wail is heard on the recording.]

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