Royalties

Royalties for licensing intellectual property (IP) such as patents and trademarks are paid to licensors by licensees. The licensors, among other reasons, enter into licensing agreements when they do not have the capital to commercially exploit their patents. In exchange for licensors substantially conveying the rights to their patent, the licensees usually agree to exclusively manufacture, market and distribute their products. Since there are no absolute formulas for determining the market royalty rate of any patent, the agreements between licensors and licensees are difficult and often debated. The agreements may require a decreasing royalty rate or amount as the product’s retail price declines over its life cycle. The licensees may receive more royalties as their products increase in sales volume over their economic lives.

IP surveys consistently demonstrate that there is a large variation of royalty rates even in the same industry. A 2001 comparison of IP transactions with royalty payments by the Financial Valuation Group (FVG) reveals that 24% of the licensing agreements are based on a fixed percentage and 26% on a fixed dollar amount. The database also reveals that the average royalty rate was 7.83% with the highest and lowest rates at 75.00% and .003%, respectively. The electronics industry, for instance, represents 25% of FVG’s database and patents represent 22% of the database.

Since every IP is unique, licensing agreements will have different royalty rates and economic structures. A fair licensing agreement may be determined by using ‘25% royalty rule’ popularized by Robert Goldscheider (Technology Management: Law, Tactics and Forms, Clark Boardman Callaghan, 1984). The rule suggests that an equitable royalty based on sales should be equivalent to 25% or the appropriate share of the licensee’s pre-tax profit from the use of the license. As Goldscheider states in ‘The Negotiations of Royalties and Other Sources of Incomes From Licensing’ (IDEA, The Journal of Law and Technology, 1995, No. 1, Vol. 36), a baseline allocation of 25% assumes that the licensee assumes the greater risk though the licensor may offer a ‘strong technology bundle’ (of intellectual property and other intangible assets). This rule has been used persuasively in the presentation of expert evidence when a court requires a reasonable estimate of hypothetical royalties in a dispute involving intellectual property infringement. A study published in 1999 of industry royalty rates in 1991 by Rose Ann Dabek with Procter & Gamble partly corroborates. The electronics industry had royalty rates between from 2% to 25%, with half the rates between 2% to 5%, according to her study. The FVG and Dabek studies, however, do not mention the related economic benefit of the rates.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

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