Royalty Rates for Licensing

AuthorRussell L. Parr
ProfessionPresident of Intellectual Property Research Associates
Pages237-271
CHAPTER 16
ROYALTY RATES FOR LICENSING
The Intellectual Property Age is on us, trending away from independence and toward a
vital need for the talents of others. Gaining rights to intellectual property is accomplished
by creating it, licensing it, or sharing it as a joint venture. As we have discussed earlier
in this book, access to intellectual property is time sensitive—it is needed now. Sharing
intellectual property is a concept many will nd difcult to accept, but accept it they must.
Denis Waitley writes in Empires of the Mind,1
The leaders of the present and the future will be champions of cooperation more often than
of competition. While the power to maintain access to resources will remain important, “the
survival of the ttest” mentality will giveaway to survival of the wisest, a philosophy of under-
standing, cooperation, knowledge, and reason.
Access to vital resources has changed because the nature of the most important
resources is no longer embodied in xed material assets. Gaining access to technology
means cooperating with other companies, even competitors, in order to gain access to their
knowledge-based resources. Independence is being replaced by interdependence. Waitley
succinctly explains,
The future leaders will only get what they want by helping others get what they want.
ROYALTY RATE BASICS
The essence of royalties is that they are a sharing of the economic benet derived from
the licensed property between the licensor and licensee. This chapter will discuss the many
different characteristics of a licensed property and the terms of the license and their effect on
the amount of the royalty to be paid. Paramount is the relative contributions of the licensee
and licensor for commercial deployment of the licensed property. When a licensee must
invest in product design, development,and testing, a lower royalty rate is implicated. When
a licensee can easily and quickly incorporate a licensed property into its operations and
prot-making activities, a higher royalty rate is indicated.
Royalty rate negotiations are based on the future expected earnings the licensed property
is expected to generate coupled with consideration for the pain associated with realizing
the expected earnings.
Getting access to intellectual property through licensing involves a royalty payment.
Royalties are based on sales or units. Sometimes a one-time lump-sum is made with no
1Denis Waitley, Empires of the Mind: Lessons to Lead and Succeed in a Knowledge-Based World (New York:
William Morrow,1995), p. 8.
237
238 Ch. 16 Royalty Rates for Licensing
additional obligations to the licensee. Sometimes compensation for a license takes the form
of granting access to other intellectual property: cross-licensing. In cross-licensing, some-
times no money exchanges. Regardless of the form of the royalty, it is paid for access to
licensed intellectual property.
RUNNING ROYALTY, PERCENT OF SALES. The most common form of royalty payment for
licensing is a running royalty. With running royalties, payments are made as the licensed
intellectual property is used. Most often, the licensee pays a portion of their sales as a
royalty.
In the sports industry, Easy Golf Corp. manufactures and sells a proprietary golf
improvement product known as “The Swing-Channel™ Golf Mat,” Easy Golf pays
the inventor 5% of sales.
Inthe medical industry,Bausch & Lomb entered into an exclusive worldwide license
agreement to develop, manufacture, and market a cast-molded multifocal soft con-
tact lens using Unilens’s patented multifocal soft contact lens design. Bausch &
Lomb pays Unilens a royalty ranging from 3% to 5% of the product’s worldwide
sales.
In automotive, Research Frontiers, Inc. licenses Glaverbel SA the rights to manu-
facture and sell self-dimmable automotive vehicle rearview mirrors. Glaverbelpays
Research Frontiers 5% of sales.
In communications, TechAlt, Inc. produces a secure wireless communications
toolset to be used by emergency rst responders for interagency interoperability,
communication, and collaboration. TechAlt pays a royalty of 5% of sales for the
underlying technology.
RUNNING ROYALTY, PER UNIT. The nancial terms of a license agreement can involvea
running royalty rate that is based on per unit of output from using the licensed technology.
Examples include:
Madison Avenue Capital, Inc. pays a royalty of $6 per tree for the licensing of a
genetically enhanced tree.
A-Gas Pty Ltd. of Australia licenses a proprietary enzyme-based fuel-enhancing
product from Virtual Technologies Pty Ltd. A-Gas pays $4.75 per kilogram for pro-
duction and distribution rights.
Whelan EnvironmentalServices Ltd. licenses technology that allows for the rening
of used oil from Interline Resources. Whelan pays a royalty of 6 cents per gallon of
oil processed.
Hybrid Fuel Systems, Inc. is in the business of manufacturing and marketing retrot
systems for the conversion of gasoline and diesel engines, stationary or vehicular,
to non-petroleum-based fuels such as compressed natural gas and liqueed natural
gas. They pay Harrier, Inc. a royalty of $250 to $1,000 per engine.
Allwaste Recycling, Inc. licenses an advancedoperational system that utilizes recy-
cled broken glass (known as cullet), usually only suitable for landlls, to produce
an end product the company has named “Glassour,” a furnace-ready raw material
for berglass insulation and potentially suitable for glass container manufacturers.
Allwaste pays Eftek Corp. a royalty of $5 per ton.
RoyaltyRateBasics 239
License agreements are based on expectations. Both parties consider the extent to which
the licensed property will be used. Both parties have knowledge about the market in which
the property will be commercialized and have some idea about the level of sales that will be
achieved and the length of time the property will be useful in the future. A running royalty
is a pay-as-you-go scheme and protects both the licensee and licensor from unforeseen
events. If future events exceed expectations, the licensor gets to participate in this happy
event. When events are not as good as expected, the licensee does not end up paying for
property that is not as useful as anticipated.
Per-unit royalties protect licensors from falling prices. In competitive industries,
licensees often ght for market share using price competition. As product prices are
reduced, royalties based on a percentage of sales may yield lower royalty payments for
licensors. A per-unit royalty provides protection but at a price because if product prices
increase, a percent-of-revenues royalty schedule allows the licensor to enjoy a portion of
increasing prices. A xed per-unit royalty does not.
LUMP-SUM ROYALTY. Another nancial arrangement associated with license agreement
can involve a one-time lump-sum patent. It is a one-and-done payment scheme. After mak-
ing a lump-sum payment, the licensee is free to use the licensed intellectual property into
perpetuity. An example is presented in the following.
Pioneer Hi-Bred International, a DuPont Company, agreed to pay royalties to Monsanto
for the use of the Bt gene (Bacillus thuringiensis) that instructs a corn plant how to make
a natural insecticide that kills the European corn borer. Pioneer paid Monsanto a one-time
$38 million fee in 1993 for the license to use the Bt gene.2
Both parties bear some risk with this payment scheme. If the licensee has success with
the property beyond initial expectations, the licensor does not participate in the happy event.
If events turn out poorly, the licensee does not get a refund and has paid for a property that
is not useful. This can happen if new technology supplants the licensed technology or sales
of the product incorporating the licensed property fall short.
One way to determine a lump-sum payment is to calculate the present value of future
royalty payments. This requires estimating sales for each year in the future for which a
royalty would be due and then calculating a present value based on a discount rate reecting
the risk of commercialization. However, there is something else that a licensee givesto the
licensor beside a lump-sum payment.
A deal based on a running royalty rate allows the licensee future options. If the product
using the technology fails in the market, the licensee can cease operations and cease making
royalty payments. The same is true if a superior technology becomes available. In that case,
the licensee can stop paying its rst licensor and strike a deal with the owner of the superior
technology. Further, if the licensee developed its own alternative technology, the licensee
can cease using the licensed technology,cease making royalty payments, and focus on using
its own technology. When a licensee enters into a deal based on a lump-sum royalty, the
option to cease making royalty payments in the future is sacriced. Giving up this option
has value. A lump-sum deal looks like the following.
Licensee Commitment =Present Value of Future Royalties
+Present Value of Future Royalty Saving Options
2In the book Lordsof the Harvest, former executives from Monsanto criticized this deal as being nearly a giveaway
of valuable rights to Pioneer. A later lawsuit between these twocompanies changed the terms of this deal.

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