Business licensing technology be warned; there's no easy formula when it comes to royalties
What royalty should we expect for our technology?
That's the million dollar question for businesses looking to license out their technology. In other words, how are they going to get rich?
It is not a question that is easily answered.
Royalties are determined by applying a rate (usually a percentage) to a base (usually some definition of sales).
For decades many practitioners have used a particular rule of thumb for determining a likely royalty rate range, dubbed the '25% rule'. Under this rule, projected profits to the licensee are the starting point. The assumption is the innovator should be entitled to about 25% of the gross operating profit from the innovation.
Some who like this rule advocate allocating and deducting non-manufacturing operating expenses relating to the product, in addition to the cost of sales. The operating profit should be before interest and tax.
The application1 of the 25% rule will often give an unrealistically high figure - and other factors may be taken into account to lower the royalty rate. Adjustments to a royalty established under the 25% rule should be made with regard for factors like licensee competencies resulting in low cost of sales relative to that of competitors, the strength and breadth of IP2 protection and the availability of viable substitutes.
Part of the difficulty with the 25% rule is that there are many interpretations of it, which can lead to very different results.
These difficulties, and the validity3 of the rule itself, were vividly brought to light in the Uniloc case, decided in January 2011 by the US Court of Appeals for the Federal Circuit. The court ruled the 25% rule inadmissible, saying it had no scientific or empirical basis and did not tie a reasonable royalty base with the facts of the case.
The million dollar question just got harder to answer.
Regardless of whether the US court considered the rule admissible, I'm sure many licensing professionals will continue to use it as, at the least, a yardstick in their royalty negotiations - if only because it is fairly quick and simple.
How else do decide appropriate royalty rates?
Royalty rates for groups of technologies based on established and successful licensing arrangements may be useful4. Benchmarking against similar products or technologies relies on the availability of sufficient public information.
Research companies may, for a fee, provide royalty information on products and industries, based on surveys and data from various sources. Royalty Source (royaltysource.com) and Tech Agreements (techagreements.com) are examples of such companies. There are also published studies of royalty rates that can be accessed freely (see the studies published5 by the Licensing Executives Society International).
However, there are inherent difficulties using this methodology. Most deals between businesses, other than publicly listed companies, are confidential and not published. By definition, a patent6 is given to a unique innovation, so how do you find truly comparable technology?
Licensing deals can vary enormously in their terms, from upfront payments, duration, territory and exclusivity to minimum performance requirements and the supporting IP that's licensed, such as trademarks or know how. All will impact on the royalty rate and whether the deal is truly comparable.
There is no easy shortcut to determine an appropriate royalty rate. Lots of steps are needed: a thorough analysis of the technology, the competitive landscape, the scope of the IP protection, the available comparable deals, the value of the patented product in promoting sales of other non-patented items, the profitability of the patented product and the proportion of that profit directly attributable to the patented features, the degree of innovation and the actual terms proposed for the licence7.
Whether you use a rule of thumb like the 25% rule or a full economic analysis to justify the royalty rate you put forward in your licence negotiation, one thing is for sure - your counterpart will have a very different number on their piece of paper. The reasonable royalty rate will only be settled through robust negotiation.
This article first appeared in Unlimited Magazine and was written by Simon Rowell.
1In most jurisdictions patent applications are
subjected to an examination process to determine whether
the subject matter is novel and inventive. The
terms "application", "pending" or "patent
application" are used to describe the status of the
application up to grant.
2Refers to the ownership of an intangible thing - the innovative idea behind a new technology, product, process, design or plant variety, and other intangibles such as trade secrets, goodwill and reputation, and trade marks. Although intangible, the law recognises intellectual property as a form of property which can be sold, licensed, damaged or trespassed upon. Intellectual property encompasses patents, designs, trade marks and copyright.
3A patent is valid if it is legally enforceable. This means that it must fulfil the criteria of patentability and not be able to be invalidated by a patent revocation proceeding. It is possible that a granted patent may not be valid, or at least its validity could be questionable. Ultimately, only the Courts can judge the validity of a granted patent.
4The document that accompanies a patent application. It defines the scope of the invention in the claims and provides a detailed description of the nature, use and purpose of the invention. A specification may be provisional or complete and there are different rules applying to each.
5At some point a patent application is published, meaning its contents are available for anyone to read. In New Zealand publication occurs when a patent application is accepted. However, in most countries publication occurs 18 months after the application is filed.
6A proprietary right in an invention which provides the owner with an exclusive right for up to 20 years to make, sell, use or import the invention. In exchange for this monopoly the patent is published so that others can see how the invention works and build on that knowledge. The patented invention may also be used by the public once the patent lapses.
7A legal document granting another party permission to use an invention that is the subject of a granted patent. The details of a licence depend on the arrangement agreed by the parties, but normally a licence fee and/or royalties will be payable.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
James and Wells is the 2010 New Zealand Law Awards winner of the Intellectual Property Law Award for excellence in client service.