Royalty rate assessment

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[edit] Introduction to Assessment Methodolgies

Royalty Rate Assessment is a practical tool to gauge the impact of a royalty commitment in a technology contract to the business interests of the contracting parties. In this coverage, the terms 'royalty rate' and 'royalty' are used interchangeably.

The proprietor of valuable Intellectual Property who has spent large sums of money to develop and then, possibly, patent a product, process or system or a proprietor who has established a reputed trademark for a product or service, will strive to recoup, by the process of contracting the right-of-use of technology, the expenditure incurred on technology development, or trademark promotion, in the quickest possible time and to obtain a profit from each of the markets in which the technology or trademark is exploited, while protecting the misuse thereof .

The user, or licensee, of the proprietory right risks loss of capital by uncertainties in the quality of the rights being acquired and the uncertainties of any marketplace. The licensee's objective would be to, correspondingly, minimise exposure to costs and the performance of the technology.

This contrast in objectives will normally be settled by a resolution of expectations. One of the key elements of this resolution process is the royalty applied, amplified here. The royalty is not a single separate element but is a composite of the rate, the length of time over which it applies, the unit base of its calculation, the 'remaining life' of the licensed right (for instance, the balance life of a patent), supportive assistance and other contractual obligations.

But fundamental to this exercise, to both the parties to a contract, is the competitiveness of the product, process, service or like entity. If there are rival products or services available to the licensee, or if there are more favourable markets for the licensor, the compromising equation changes in context.

It is to be noted that the cost to the licensor in developing a technology, or the cost of building the value of a trademark or the normal market risks of the licensee in the choice of product, and concomitant capital costs, are not generally part of the compromise equation, significant as these factors may be to each of the negotiating parties. However, such costs do become pertinent when a technology is licensed out prior to its maturity (See Technology Life Cycle).

[edit] Typical Royalty Rates

'Typical royalties' are historically applied royalty rates. To understand the concept of 'typical royalties' one must infer that the term 'royalty' originally applied to the 'share of the proceeds' that the Crown demanded of its subjects for any exploitation of the assets owned by the Crown, for instance, mines, shipping lanes, geographic territories and the like. Besides the implication of sharing the proceeds of an operation, the payment of royalty was expressly an acknowledgement that the exploited property remained in the hands of the Crown; in other words, any exploitation was by a way of lease or franchise and not through sharing or transfer of ownership. Today this concept carries over to the absolute ownership of property in Intellectual Property rights (IPR), whether that resides in a product, process or system by a governmental, corporation or like entity.

Where there is lack of knowledge of the analytical concepts in royalty, the general tendency is to use mineral mining royalties as a base reference. Historically, royalties in the region of 1.0 to 3.0% have prevailed, the unit-base being 'sales value' of the exploited product. Little consideration is given to the character of the product or process being licensed, the nature and profitability of the market-place or the 'remaining life' of the licensed entity. In a slightly modified form, typical rates applied in the industry to which the product belongs is used; for instance, in the textiles, chemicals or auto-component industries.

As will be seen shortly, such arbitrary negotiation of royalty rates holds danger for both the proprietor/licensor of technology and its user/licensee. In a poorly profitable market, the licensee stands to lose disproptionately, and in a very profitable market, the licensor.

[edit] Royalty Rate as Profit Share

To start with, a very simple illustration is provided to describe the profit-sharing concept, which will be expanded upon subsequently.

Any enterprise marketting a product would expect to obtain a profit which is some percentage of its sales price. If the product arises from working a license, then its licensor would want to share a part of that profit. (It is to be noted that the licensed product can be expected to command a higher price in the market-place than its competitor by virtue of higher yield, lower cost, better quality, convenience or other factors). In the discussion below, the royalty term that is illustrated is 'royalty on sales' with the sale involving one unit of product. (Other forms of royalty are discussed later).

Arithmetically, royalty (on sales) can be expressed as:

Royalty = Payment-to-licensor/Product-sales-price

or re-expressed as

Royalty = Licensor-profit/Product-sales-price

or as

Royalty = Licensor-profit/Enterprice-profit x Enterprise-profit/Product-sales-price

or more formally as

  ROS = LSEP x POS    (A)

where:

ROS = Royalty on Sales price
LSEP = Licensor's Share of Enterprise Profit
POS = Profit on Sales (price)

Thus, if a licensor wants to receive a 20% share of the enterprise's (licensee's) profit (LSEP) on a product that sells for $5, and on which the licensor estimates the licensee's profit would be $1.50, the licensor would negotiate to apply a royalty rate (ROS) of 6% on the sales price. (POS=$1.5/$5.0=$0.30).

(The terms 'price' and 'profit' as used here are undefined; they will receive greater precision in later discussion).

Expression (A) above can be re-expressed as:

     LSEP = ROS/POS      (B)

It exhibits an important facet of the royalty rate concept. For a given royalty rate (i.e. ROS), the licensor obtains a greater percentage of the profit on the product the lower the profitability of the product (and, vice versa, the enterprise gives away a smaller share of the profit to the licensor for a product of high profitability).

It is important to differintiate between the percentage share of the licensor in the profit from the percentage royalty rate which is its most common form of statement.

[edit] Royalty Rate and the Technology Turnover Concept

A more elegant - and algebraic - way of looking at royalty payment would be to regard it together with the other quantitative elements of technology assessment and to avoid the various forms of royalty expression such as 'running royalties', unit royalties, lumpsum or 'front-end' payments or their combinations which tend to obfuscate the issue (but are nonetheless normal part of commerce).

Table A below demonstrates what could happen in a license agreement in a case where, commencing from the first year of the license, there is a flow of income and payments by the licensee enterprise to the licensor. For purposes of illustration it is assumed that the royalty-payable-period is of 5 years duration with a fixed royalty rate and that annual sales volume and cost of production remain unaltered.

Table A. Schematic of Incomes and Cost Flows
Unit:'000$
Year --> 1 2 3-5 6
Sales 100 100 100 100
Cost of Production 40 40 40 40
Royalty Due,R 4 4 4 0
Total Cost 44 44 44 40
Profit before Tax, PBTR 56 56 56 60 (PBT)

It is evident that in the 6th year, the profit to the enterprise increases by $4000, which has been hitherto a part of 'accountants cost' before deduction of income tax. (Amortization, interest on borrowed funds, etc. are assumed included in 'production cost' to simplify the concepts).

The higher income to the licensee in the 6th year would not be apparent if assessment was limited to the first 5 years of royalty commitment.

Algebraically,

 LSEP= R/(PBTR+R)   - C

where:
LSEP is the licensor's share of licensee's profit (see Expression A above)
R is the absolute amount of royalty paid
PBTR is the profit-before-tax amount during the royalty-applicable period

Expression C can be rewritten as:

 LSEP = 1/ (1 + PBTR/R) - D

or as

 LSEP = 1 / (1+TTF)     - E

where TTF is defined as the Technology Turnover Factor. It is a measure of the profit or return that the enterprise obtains for a unit of royalty payment - a profit accelerator. A high TTF implies a lower share of enterprise profit flows to the licensor (and conversely, a higher share to the licensor when the TTF is small). The evaluation of Expression E and that of TTF provide estimates of commitments to the licensor (technology-offering party) in accepting a license at a particular royalty rate, while also forming a base for negotiations of this and other aspects of a license.

Expression C also defines the term 'profit' for this analysis; it is the profit-before-tax during the royalty-bearing period and not that of the post-royalty period (PBT). Thus, taxation rates do not come into play and it is possible to evaluate royalties independent of them in a territory or across territories provided profitscan be projected over the license period.

Of course, in normal business practice, royalty rates take on different forms, while sales, costs and profits vary from year to year. Unless they can be reduced to consolidated (single) numbers, the practical use of Expressions (D) and (E) would not be feasible. However, in the following coverage it is shown that all formats of royalty expression, and yearwise variations of incomes and costs, can be reduced to simple unified numbers of 'Present Value'.

[edit] The 'Present Value' Method of Capitalizing a Flow of Numbers

The concept of Present Value is routinely used in financial analysis of projects to make a selection where there are alternative financing modalities. Its objective is to capitalize periodic and variously distributed incomes and costs of the enterprise by discounting future receipts and costs in terms of their 'present value' (PV). This may appear to be complicated but it is not.

If $0.9091 is banked today at an interest rate of 10%, its value at the end of a year would be $1.00. Conversely, $1.00 received (or spent) one year from now is equivalent to its Present Value of $0.9091. It can also be said that the discounted value of $1.00 one year from now is equal to $0.9091 at 10%. Similarly, $0.8264 is the PV of $1.00 receivable two years from today at the 10% rate.

The term 'interest rate' used above is an approximation for the economist's discount rate -the cost of capital. It is not the inflation rate or the bank rate.

The discount factors (DF) of 0.9091 and 0.8264 are obtained from the 'compound interest' formula:

DF = 1/(1+ r)n

where

r is the discount rate
n is the forward year from current day = 0

It then becomes possible to reformulate a stream of profits and royalties to their Present Values (PV). The sum of PVs is the Net Present Value (NPV). (See Net Present Value, which discussion also extends to the Discount Rate).

For evaluating LSEP and TTF, only PBTR and royalties payable for each year are needed to obtain LSEP and TTF.

Table B illustrates this methodology for evaluating the projected LSEP of an enterprise, where royalty is applicable for a period of 5 years.

Table B. Illustrative Projected Flows of PBT and Royalty of an Enterprise [Unit:000$]
Year --> 1 2 3 4 5
Sales 700 900 1200 1600 2200
PBT 75 105 130 200 280
Royalty 60 36 48 64 88
Discount Factor,10% 0.9091 0.8264 0.7531 0.6830 0.6209
Discounted PBT 68.2 86.8 97.7 136.6 173.9
Discounted R 54.5 29.8 36.1 43.7 54.6


The NPVs of PBT and R are $563,100 and $218,700,respectively, and thus, the projected LSEP is 0.28 i.e. the licensee sheds 28% share of the profits of the enterprise to the licensor over its five year period (should profit expectations be met). Profit projection data is made by the licensee and would not be generally known to the licensor.

The sales data shown in the table is not relevant to the calculation of LSEP. It is, however, an estimation the licensor would need to know prior to negotiating the technology agreement. On this basis,the licensor has applied a 4% royalty on sales value for the 5-year period of the license, with an additional lumpsum payment of $32000 on execution of the license.

The TTF of this projection is 2.6, implying that for every dollar of royalty paid, the profits to the licensee enterprise (before income taxes) is multiplied by that factor.

It is to be noted that PBT and PBTR are identical in Table B since all calculations pertain only to the royalty-bearing period of the license. Also, there are no restrictions on providing for interest costs, depreciation and amortization costs, etc before the resultant PBT. Should there be a tax on royalty, the relevant royalty to use is the gross tax before the tax on it.

Normal project calculations look beyond the royalty-bearing period evaluating both the NPV and the <IRR> Internal rate of return.

[edit] Royalty Rate Expressions

Royalty in licence agreements is always in consideration (a legal term) of something that is provided by the licensor in the agreement, such as the right to use a trademark or patent, the license to use 'knowhow', the delivery of designs, engineering drawings a product, documents, their combinations and the benefits obtained by the contracting parties.

Royalty payments take three baisc forms:

  • 'running' royalties
  • 'lumpsum' royalty
  • running royalties and lumpsum royalties

Before elaborating on them, it must be recognized that any payment would be related to:

  • the specific element that bears the royalty
  • the quantum over which the royalty is applicable
  • the duration of the period over which payments are to be made
  • when the payments have to be made, currency and mode
  • mutual obligations of the licensor and licensee to each other.

For example, in a product licensing agreement the licensee may be obliged to make a a lumpsum royalty of $100,000 on execution of agreement together with royalty of 4% of the 'net sales value' for all products sold under license for a period of 6 years commencing 2 years from the date of starting production with no rights granted to export outside of 'territory of license' but with the rights provided (by the licensor) to receive 'improvements in technology' over the period of the agreement and to the continuing use of knowhow, observing confidentiality of knowhow, after lapse of the agreement period.

The selection of the royalty format is not arbitrary. Each form of compensation has advanatges and disadvanatges to the contracting parties. What follows is a just an introduction.

Running Royalties

Running royalties are predominantly used in patent, trademark and franchise licensing since they can theoretically be exploited without any other inputs from the licensor once the license has been entered into with its caveats.

Where there is only one product or service the royalty base can be either the number of units produced or sold (the distinction is significant) or the 'sales value' (sales realization)of the product or service. Where the term 'sales value' is the base unit, it has to be very strictly defined, whether it is 'gross sales value' or 'net sales value' (NSV), and if the latter, what components of the price need to be subtracted; for instance, packing cost, sales taxes, transportation costs, etc. NSV is predominantly used when there are a multiplicity of products made or processed in some way (say, various thicknesses of plate glass in a glass-manufacturing license).

In some circumstances there may be minimum and maximum (cut-off) royalty stipulations. Minimum royalties are used whem there is the possibility that the licensee may not work the license to its full benefit or as an incentive to work it to the full. The maximum or cut-off royalty can be negotiated when the licensor agrees that a cumulativee amount will satisfy the objectives of license; once the limit is reached, no further royalties are due (although the caveats of the license apply). An alternative is a negotiation for reducing royalties on the basis of quantum or time.

Lumpsum Royalties

Lumpsum royalties are most often encountered when the principal contribution of the licensor is providing formulae, documentation, designs and the like. That is, once the transmission of the latter is completed, the licensor has no involvement with the licensee so long as the caveats and rights of the license are respected. In some cases, the lumpsum merely represents the 'capitalization' (PV) of a part of the runnimg royalties.

Combined Lumpsum and Running Royalties

This combination of royalties is met with in 'technology contracts' where more than one form of intellectual property is licensed out combined, possibly, with a knowhow license, and in many cases, with a straight knowhow license alone.

Where the transfer of knowhow is the solely the province of contract, the lumpsum often works as 'insurance' against misuse of knowhow by the licensee, since there is no protective statute for it (unlike with Patents and Trademarks), while the 'running royalty' can be insurance for the licensee in that the licensor would provide inputs so as to maximize income (thus to the benefit of both). Alternatively, the running payments may be to spread an otherwise lumpsum component.

[edit] Technical Assistance Fees

In many contracts involving the use of knowhow (and associated IP), 'technical assistance' may be encountered as a part of the contractual process, particularly in developing country contracts. The assistance comprises services which are not in the nature of IP but are needed by the licensee to accomplish its objectives. They are of a specialized nature linked to the knowhow, for instance, procurement of equipment, the setup of a production facility or training of licensee personnel, on-site and off-site. These costs would bear no relationship to the royalties, although they are most often provided by the licensor.

The cost of such services arises from delineating the skill-mix and 'man'-hours of effort involved (domestic and expatriate personnel) and providing for supervision overhead. The costs of different skills is in the public domain and can be readily estimated. The overhead percentage, however, is a negotiated element

[edit] References

  • Guidelines for Evaluation of Transfer of Technology Agreements, United Nations, New York, 1979.
  • Manual on Technology Transfer Negotiation, United Nations Industrial Development Organization, Vienna, Austria, 1996 (Modules 6 and 16), 1996.
  • Licensing Guide For Developing Countries', World Intellectual Proporty Organization (WIPO), 1977.
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