Use of the 25% Rule in Valuing Intellectual Property

• Author: Russell L. Parr
• Profession: President of Intellectual Property Research Associates
• Pages: 272-290

CHAPTER 17

USE OF THE 25% RULE

IN VALUING INTELLECTUAL

PROPERTY

Robert Goldscheider, John Jarosz, and Carla Mulhern

INTRODUCTION

As the importance of intellectual property protection has grown, so has the sophistication of

tools used to value it. Discounted cash ow,1capitalization of earnings,2return on invest-

ment,3Monte Carlo simulation,4and modied Black-Scholes option valuation methods5

have been of great value. Nonetheless, the fairly simple 25% rule is over 40 years old, and

its use continues. Richard Razgaitis has called it the “most famous heuristic, or rule of

thumb, for licensing valuation.”6

The rule suggests that the licensee pay a royalty rate equivalent to 25% of its expected

prots for the product that incorporates the intellectual property at issue. The rule has been

used primarily in valuing patents, but has been useful (and applied) in copyright, trade-

mark, trade secret, and knowhow contexts as well. The rule came into fairly common usage

decades ago; times, of course, have changed. Questions havebeen raised on whether the fac-

tual underpinnings for the rule still exist (i.e., whether the rule has much positive strength)

such that it can and should continue to be used as a valid pricing tool (i.e., whether the rule

has much normative strength).

In this chapter, we will describe the rule, address some of the misconceptions about

it, and test its factual underpinnings. To undertake the latter, we have examined the

1D. J. Neil, “Realistic Valuation of Your IP,” Les Nouvelles 33, The Journal of the Licensing Executives Society

(December 1997): 182; Stephen A. Degnan, “Using Financial Models to Get Royalty Rates,” Les Nouvelles 33,

The Journal of the Licensing Executives Society (June 1998): 59; Daniel Burns, “DCF Analyses in Determining

Royalty,” Les Nouvelles 30, The Journal of the Licensing Executives Society (September 1995): 165; Russell L.

Parr and Patrick H. Sullivan, Technology Licensing: Corporate Strategies for Maximizing Value (New York:

John Wiley & Sons, 1996), pp. 233–246; Richard Razgaitis, Early-Stage Technologies: Valuation and Pricing

(New York:John Wiley & Sons, 1999), pp. 121–158.

2Robert Reilly and Robert Schweihs, ValuingIntangible Assets (New York: McGraw-Hill, 1999), pp. 159–166.

3Par and Sullivan, Technology Licensing, pp. 223–233.

4V.Walt Bratic et al., “Monte Carlo Analyses Aid Negotiation,” Les Nouvelles 47, The Journal of the Licensing

Executives Society (June 1998); Razgaitis, Early-Stage Technologies,pp. 160–177.

5Nir Kossovsky and Alex Arrow, “TRRU™ Metrics: Measuring the Value and Risk of Intangible Assets,” Les

Nouvelles 35, The Journalof the Licensing Executives Society (September 2000): 139; F. Peter Boer, The Valuation

of Technology:Business and Financial Issues in R&D (New York: John Wiley& Sons, 1999), pp. 302–306.

6Razgaitis, Early-Stage Technologies,p. 96.

272

History of the Rule 273

relationship between real-world royalty rates and real-world industry and company prot

data. In general, we have found that the rule is a valuable tool (rough as it is), particularly

when more complete data on incremental intellectual property benets is unavailable. The

rule continues to have a fair degree of both positive and normative strength.

HISTORY OF THE RULE

According to some sources, the 25% rule was formally developed decades ago by one of

the authors: Robert Goldscheider.7Goldscheider did in fact undertake an empirical study

of a series of commercial licenses in the late 1950s.8This involved one of his clients, the

Swiss subsidiary of a large American company, with 18 licensees around the world, each

having an exclusive territory. The term of each of these licenses was for three years, with

the expectation of renewals if things continued to go well. Thus, if any licensee “turned

sour,” it could be replaced promptly. In fact,however, even though all of them faced strong

competition, they were either rst or second in sales volume, and probably protability, in

their respective markets. These licenses therefore constituted the proverbial win-win situ-

ation. In those licenses, the intellectual property rights transferred included a portfolio of

valuable patents, a continual ow of knowhow, trademarks developed by the licensor, and

copyrighted marketing and product description materials. The licensees tended to generate

prots of approximately 20% of sales, on which they paid royalties of 5% of sales. Thus,

the royalty rates were found to be 25% of the licensee’s prots on products embodying the

patented technology.9

Goldscheider rst wrote about the rule in 1971.10 He noted, however, that it had been

utilized in some form by valuation experts prior to that.11 For example, in 1958, Albert

S. Davis, the general counsel of Research Corporation, the pioneer company in licensing

university-generated technology, wrote: “If the patents protect the Licensee from competi-

tion and appear to be valid, the royalty should represent about 25% of the anticipated prot

for the use of the patents.”12

A form of the rule, however,existed decades before that. In 1938, the Sixth Circuit Court

of Appeals, in struggling with the problem of determining a reasonable royalty,heard expert

testimony to the effect that “ordinarily royalty rights to the inventor should bear a certain

proportion to the prots made by the manufacturer and that the inventor was entitled to a

‘proportion ranging from probably ten percent of the net prots to as high as thirty percent,’

which should be graduated by the competitive situation.”13

Regardless of its origins and author(s), the concept has aided intellectual property valu-

ators for many years.

7See, e.g., Richard S. Toikka,“In Patent Infringement Cases, the 25 Percent Rule Offers a Simpler Wayto Calculate

Reasonable Royalties. After KumhoTire, Chances Are the Rule Faces Challenges to Its Daubert Reliability,” Legal

Times (August 16, 1999), p. 34.

8Robert Goldscheider, “Litigation Backgrounder for Licensing,” Les Nouvelles 29 (March 1994): 20, 25; Robert

Goldscheider, “Royalties as Measure of Damages,” Les Nouvelles 31 (September 1996): 115, 119.

9Robert Goldscheider,Technology Management: Law/Tactics/Forms (New York:Clark Boardman, 1991), § 10.04.

10Robert Goldscheider and James T. Marshall, “The Art of Licensing from the Consultant’s Point of View,” Law

and Business of Licensing 2 (1980): 645.

11Goldscheider, TechnologyManagement.

12Albert S. Davis, Jr., “Basic Factors to Be Considered in Fixing Royalties,” Patent Licensing, Practicing Law

Institute (1958).

13Horvath v. McCord Radiator and Mfg. Co. et al., 100 F.2d326, 335 (6th Cir. 1938).