What’s A Reasonable Royalty Rate?

Among the most frequently asked questions I get from start-up companies is: How much should I pay for licensing in a technology? Answer: As little as possible. Kidding aside, this is really a very complicated question that cannot be answered without a lot of homework. While most companies seem to use a valuation method I like to call “pulling a number out of the air,” there are three primary methods used by licensing professionals to assess the value of IP assets. These are the Cost Method, Market Method and Income Method. With all of these methods, good data and data projection are critical in determining the appropriate numbers.

In the Cost Method, the value is the cost incurred in developing or purchasing the relevant technology or intellectual property. But what if, as a result of changing markets or new information, you determine that the present value of the total revenues/return expected from this technology is less that the cost?

In the Market Method, the method for determining value is to learn what comparable technologies have licensed for recently. Of course, to do this you’ll need to (a) determine what transactions are comparable and (b) obtain current, reliable data. Usually, this is through compiled data reports.

In the Income Method, value is the estimated revenues the technology is likely to produce (and savings it is likely to generate) and comparing this to the estimated cost to generate the same revenues or savings from other sources, that is, total annual returns. Basically, it’s a method of determining what you can afford (or not afford) to pay in the end.

This issue came up while I was on a panel discussion at the BioOhio conference last week (although I was in pain from my broken shoulder). It did provide some interesting insights in the need for obtaining information relating to royalty rates.

One audience member stated that he felt universities or research institutions collaborate and share licensing information, essentially leaving a potential licensee at a disadvantage with little or no information as to what the “proper” royalty rate should be for a given technology. The audience member thus posed the question: Are there sources of royalty data available to a licensee to figure out the “appropriate” royalty amount to pay (i.e., the Market Method)?

The short answer is “Yes” but I find such royalty rate sources particularly unhelpful. We didn’t have time to get into details at the time but I think that finding out the range of average royalty rates for particular products is interesting in the sense of providing a general “ballpark” range — but not really helpful for your particular product and agreement.

Organizations like the Association of University Technology Managers (AUTM) and the Licensing Executives Society (LES) publish lists and statistical analyses of royalty rates (many industries use about 5% of the selling price as a typical rate) but rates can vary from 0.1 to 25% or more and depend on the industry.

Often, such royalty guides provide some range of royalty rates for certain technologies, e.g., a rate of 4%-12% for technologies related to therapeutic products. I would argue: So, what? What does that tell you about your therapeutic? Should it be 12%? Or only 4%? Or do you split the baby and call it 8%?

Granted, using an established royalty rate shown in certain guides sounds good since these are derived from prior actual licenses for comparable products. The rates in the guides come from negotiation and paid by a sufficient number of licenses. As with reasonable royalty, an established royalty rate derives from the outcomes of willing parties licensing without the threat of a suit, or resultant from litigation. These rates are reflective of the profitability of industry segments. Correspondingly, what might pass muster for an established royalty depends upon the definition of a market segment. Commodity items tend to garner a relatively low royalty rate, just shy of 3%, consumer goods 5%, while software garners around 7-8%. But generalities don’t tell you anything about your particular deal.

Very often, universities rely on the 25% Rule. It’s often accepted (as a rule of thumb) that a royalty rate equalling about one-quarter of the licensee’s anticipated pre-tax profits derived from the technology is a fair rate. Of course, one needs to then determine net profits. Thus, the rates depend on the market forces of each particular product. For example, if the licensee will have profit margins of 80%, the royalty paid to the licensor should be about 20% of pre-tax, net revenues. Conversely, if profits of 4% are expected, the royalty should be within the range of 1-1.5% of net revenues earned.

Note, however, that this rule-of-thumb doesn’t take into account specific circumstances determining the value of your particular technology. Therefore, the 25% Rule is only a starting number before looking at many other factors that should be taken into account in the final determination of value/rate. One needs to consider: Is the technology a breakthrough or core product? Is it merely an ancillary product or minor improvement? Is the intellectual property (patents, copyrights, etc.) strong enough to make the final product unique and valuable? Is the technology ready to be used immediately or will it require substantial R&D or regulatory clearance to be commercialized? Is there a high risk of failure? Can you maintain a high profit margin or will others eat your lunch? Therefore, royalties for pharmaceuticals in the pre-clinical stage may be from 0-5%, while royalties in Phase I may be 5-10% and royalties for launched products may top 20%. Again, guidebooks and rules-of-thumb will only get you so far.

If you want to strike a deal in which the licensor thinks the price is too low, you need to provide a basis for your numbers. I recommend to clients that, if necessary, they show their business plan to the licensor under a nondisclosure agreement. That often helps the other side understand that the offer is dictated by the business model and not just an offer to get the lowest royalty rate in order to keep more of the profits for itself. For example, substantiate an expected profit percentage by preparing a manufacturing cost estimate and then apply percentages customary in the specific industry for overhead items like R&D, engineering, marketing and sales, etc. Then the total cost per unit is deducted from the expected selling price per unit to establish a gross profit.

What is more difficult is deciding how much, if any, the royalty rate should be discounted based on risk factors. It is not impossible for discount factors to be in the 25-35%/year range. To determine the ultimate reasonable royalty rate, you need to consider extraneous factors (e.g., how soon until you will be ready to sell a product and gain revenue, the exclusionary position of the patents, the competitive products, market share, etc.).

I say that the “correct” royalty rate is the maximum royalty rate that the licensee is willing to pay that meets the minimum royalty rate the licensor is willing to accept. If you are only willing to pay 3% and the university will only accept 6%, then you’ll have no deal (and I’d argue you shouldn’t!). Why front your capital on a business venture that you can’t afford to pursue?

A reasonable royalty rate is often based on economic sense by utilizing a financial model which relates the investment required to develop a therapeutic technology to the income generated by such technology. What does that mean? It means you have to have a good business plan in place before you can talk turkey on royalty rates. And I don’t mean those wildly inflated fluffy business plans that companies create showing revenue in colorful logarithmic growth charts to impress potential investors. No, I mean a real, down-to-earth, cold shower type of business plan that takes into account all of the pain and suffering that could be encountered along the way.

from patent BARISTAS