Royalties

Royalties (sometimes, running royalties) are usage-based payments made by one party (the "licensee") to another (the "licensor") for ongoing use of an asset, most typically an intellectual property (IP) right. Royalties are usually determined periodically as a percentage of gross or net sales derived from use of the asset or a fixed price per unit sold. A royalty interest is the right to collect a stream of future royalty payments, often used in the oil and gas industry to describe a percentage ownership of future production or revenues from a given leasehold, which may be divested from the original owner of the asset.

Patent Royalties

A patent gives the owner an exclusive right to prevent others from practicing the patented technology in the country issuing the patent for the term of the patent. The right may be enforced in a lawsuit for monetary damages or to prohibit use of the patent. In a patent license, royalties are paid to the patent owner in exchange for a license to practice one or more of the four basic patent rights: to manufacture, use, sale, or advertise for sale, a patented technology.

Patent rights may be divided and licensed out in various ways, on an exclusive or nonexclusive basis. The license may be subject to limitations as to time or territory. A license may encompass an entire technology or it may involve a mere component or improvement on a technology. In the United States, "reasonable" royalties may be imposed, both after-the-fact and prospectively, by a court as a remedy for infringement.

Know-How Agreements

In addition to licensing the applicable patents, a company may need to learn how to manufacture a product. This knowledge, standing alone or together with a patent license, may be obtained through a know-how license. Know-how is trade secret information in combination with data, techniques, or human and intellectual expertise, that helps a company exploit a licensed technology. Know-how may help a company achieve better operational efficiency, manufacturing productivity, or product/system quality. Know-how royalties may be stated as distinct from patent royalties since their periods of validity vary. The rates vary widely.

Trademark Royalties

Trademarks are words, logos, slogans, sounds, or other distinctive expressions that distinguish the source, origin, or sponsorship of a good or service (in which they are generally known as service marks). Trademarks offer the public a means of identifying and assuring themselves of the quality of the good or service. They may bring consumers a sense of security, integrity, belonging, and a variety of intangible appeals. The value that inures to a trademark in terms of public recognition and acceptance is known as goodwill.

A trademark right is an exclusive right to sell or market under that mark within a geographic territory. The rights may be licensed to allow a company other than the owner to sell goods or services under the mark. A company may seek to license a trademark it did not create in order to achieve instant name recognition rather than accepting the cost and risk of entering the market under its own brand that the public does not necessarily know or accept. Licensing a trademark allows the company to take advantage of already-established goodwill and brand identification.

Like patent royalties, trademark royalties may be assessed and divided in a variety of different ways, and are expressed as a percentage of sales volume or income, or a fixed fee per unit sold. When negotiating rates, one way companies value a trademark is to assess the additional profit they will make from increased sales and higher prices (sometimes known as the "relief from royalty") method.

Trademark rights and royalties are often tied up in a variety of other arrangements. Trademarks are often applied to an entire brand of products and not just a single one. Because trademark law has as a public interest goal the protection of a consumer, in terms of getting what they are paying for, trademark licenses are only effective if the company owning the trademark also obtains some assurance in return that the goods will meet its quality standards. When the rights of trademark are licensed along with a know-how, supplies, pooled advertising, etc., the result is often a franchise relationship. Franchise relationships may not specifically assign royalty payments to the trademark license, but may involve monthly fees and percentages of sales, among other payments.

Copyright Royalties

Copyright law gives the owner the right to prevent others from copying, creating derivative works, or publicly performing their works. Copyrights, like patent rights, can be divided in many different ways, by the right implicated, by specific geographic or market territories, or by more specific criteria. Each may be the subject of a separate license and royalty arrangements.

Copyright royalties are often very specific to the nature of work and field of endeavor. With respect to music, royalties for performance rights are set by the Library of Congress' Copyright Royalty Board. Mechanical rights to recordings of a performance are usually managed by one of several performance rights organizations. Payments from these organizations to performing artists are known as residuals. Royalty free music provides more direct compensation to the artists. In 1999, recording artists formed the Recording Artists' Coalition to repeal supposedly "technical revisions" to American copyright statutes which would have classified all "sound recordings" as "works for hire," effectively assigning artists copyrights to record labels.

Book authors may sell their copyright to the publisher. Alternately, they might receive as a royalty a certain amount per book sold.  Some photographers and musicians may choose to publish their works for a one-time payment. This is known as a royalty-free license.

Other Royalty Arrangements

The term 'royalty' also covers areas outside of IP and technology licensing, such as oil, gas, and mineral royalties paid to the owner of a property by a resources development company in exchange for the right to exploit the resource. In a business project the promoter, financier, or other parties who arranged for or otherwise enabled the transaction but are no longer actively interested may have a royalty right to a portion of the income, or profits, of the business. This sort of royalty is often expressed as a contract right to receive money based on a royalty formula, rather than an actual ownership interest in the business. In some businesses this sort of royalty is sometimes called an override.

Other Compensation Methods

Royalties are only one among many ways of compensating owners for use of an asset. Others include:

1. buying the asset outright, possibly with a leaseback arrangement;
2. offering the licensor an equity position in the licensee company;
3. staged milestone payments (as in drug development and commissioned software arrangements);
4. lump sum payment made to the licensor in one or more installments;
5. cross-licensing agreements with or without cash payments; and
6. entering into a strategic alliance.

Royalty Rate Determination

There are three general approaches to assess the applicable royalty rate in the licensing of intellectual property. They are:

1. Cost Approach 
2. Comparable Market Approach 
3. Income Approach

For a fair evaluation of the royalty rate, the relationship of the parties to the contract should be at 'arms-length' (related parties such as the subsidiary and the parent company need to transact as though they were independent parties) and be viewed as acting free and without compulsion.

Cost Approach

The Cost Approach considers all the elements of cost that have been employed to create the intellectual property and to seek a royalty rate that will recapture the expense of its development and obtain a return that is commensurate with its expected life. Costs considered could include R&D expenditures, pilot-plant and test-marketing costs, technology upgrading expenses, patent application expenditure and the like.  The method has limited utility since the technology is not priced competitively on 'what the market can bear' or in the context of the price of similar technologies. More importantly, by lacking optimization (through additional expense), it may earn below its potential.

However, the method may be appropriate when a technology is licensed out during its R&D phase as happens with venture capital investments or it is licensed out during one of the stages of clinical trials of a pharmaceutical.  In the former case, the venture capitalist obtains an equity position in the company (developing the technology) in exchange for financing a part of the development cost (recovering it, and obtaining an appropriate margin, when the company gets acquired or it goes public through the IPO route).

Recovery of costs, with opportunity of gain, is also feasible when development can be followed stage-wise as shown below for a pharmaceutical undergoing clinical trials (the licensee undertakes to pay higher royalties as the staged development nears its conclusion):

         Stage of development                Royalty rates,%

         Pre-clinical success                   0-5
         Phase I                                         5-10
         Phase II                                        8-15
         Phase III                                       10-20
         Launched product                      20+

A similar approach is used when custom software is licensed (an in-license). The product is accepted on a royalty schedule depending on the software meeting set stage-wise goals and specifications with acceptable error levels in performance tests.

Comparable Market Approach

Here the cost and the risk of development are disregarded. The royalty rate is determined from comparing competing or similar technologies in an industry, modified by considerations of useful 'remaining life' of the technology in that industry and contracting elements such as exclusivity provisions, front-end royalties, field of use restrictions, geographic limitations and the 'technology bundle' (the mix of patents, know-how, trade-mark rights, etc.) accompanying it.

Although widely used, the prime difficulty with this method is obtaining access to data on comparable technologies and the terms of the agreements that incorporate them. Fortunately, there are several recognized organizations, among them, RoyaltySource, Royaltystat, Knowledge Express, etc (see 'Royalty Rate Websites' listed at the end of this article) who have comprehensive information on both royalty rates and the principal terms of the agreements of which they are a part. There are also IP-related organizations, such as the Licensing Executives Society, which enable its members to access and share privately assembled data.

The two tables shown below are drawn, selectively, from information that is available with an IP-related organization and on-line. The first depicts the range and distribution of royalty rates in agreements. The second shows the royalty rate ranges in select technology sectors (latter data sourced from: Dan McGavock of IPC Group, Chicago, USA).

Income Approach

The Income approach focuses on the licensor estimating the profits generated by the licensee and obtaining an appropriate share of the generated profit. It is unrelated to costs of technology development or the costs of competing technologies.  The approach requires the licensee (or licensor): (a) to generate a cash-flow projection of incomes and expenses over the life-span of the license under an agreed scenario of incomes and costs (b) determining the Net Present Value, NPV of the profit stream, based on a selected discount factor, and c) negotiating the division of such profit between the licensor and the licensee.

The NPV of a future income is always lower than its current value because an income in the future is attended by risk. In other words, an income in the future needs to be discounted, in some manner, to obtain its present equivalent. The factor by which a future income is reduced is known as the 'discount rate'. Thus, $1.00 received a year from now is worth $0.9091 at a 10% discount rate, and its discounted value will be still lower two years down the line.

The actual discount factor used depends on the risk assumed by the principal gainer in the transaction. For instance, a mature technology worked in different geographies, will carry a lower risk of non-performance (thus, a lower discount rate) than a technology being applied for the first time. A similar situation arises when there is the option of working the technology in one of two different regions; the risk elements in each region would be different.

The method is treated in greater detail, using illustrative data, in Royalty Assessment.

The licensor's share of the income is usually set by the '25% rule of thumb', which is said to be even used by tax authorities in the US and Europe for arms-length transactions. The share is on the operating profit of the licensee firm. Even where such division is held contentious, the rule can still be the starting point of negotiations.

Three aspects to the profit of the enterprise must be noted:

1. the profit that accrues to the licensee may not arise solely through the engine of the technology. There are returns from the mix of assets it employs such as fixed and working capital and the returns from intangible assets such as distribution systems, trained workforce, etc. Allowances need to be made for them. 
2. profits are also generated by thrusts in the general economy, gains from infrastructure, and the basket of licensed rights - patents, trademark, know-how. A lower royalty rate may apply in an advanced country where large market volumes can be commanded, or where protection to the technology is more secure than in an emerging economy (or perhaps, for other reasons, the inverse). 
3. the royalty rate is only one aspect of the negotiation. Contractual provisions such as an exclusive license, rights to sub-license, warranties on the performance of technology etc may enhance the advantages to the licensee, which is not compensated by the 25% metric.

The basic advantage of this approach, which is perhaps the most widely applied, is that the royalty rate can be negotiated without comparative data on how other agreements have been transacted. In fact, it is almost ideal for a case where precedent does not exist.

It is, perhaps, relevant to note that the IRS also uses these three methods, in modified form, to assess the attributable income, or division of income, from a royalty-based transaction between a US company and its foreign subsidiary.

Patent Royalty Rates

Patent royalty rates rates are influenced by the importance of the patent and its value to the products. Some realms of business have conventions regarding royalty rates and other license terms. Royalties are often computed as a percentage of the value of the finished product made by using the patent. To illustrate, the following are prevalent rates within the United States pharmaceutical industry:

1. a pending patent on a strong business plan, royalties of the order of 1%
2. issued patent, 1%+ to 2%
3. the pharmaceutical with pre-clinical testing, 2-3%
4. with clinical trials, 3-4%
5. proven drug with US FDA approval, 5-7%
6. drug with market share, 8-10%

Royalty rates may also be affected by whether a patent is strong (i.e. broadly written, seemingly valid) or weak; whether it is a fundamental patent or merely a slight improvement on a known technology; whether substitute technologies are available or an ability to work around the patent; the extent of the contribution of the patented technology to the value of the final product and whether there are other patents that must also be licensed (in which case there is a practical limit on how much royalty can be paid to license each).

Trademark Royalty Rates

In a long-running dispute involving the valuation of the DHL trademark of DHL Corporation, it was reported that experts employed by the IRS surveyed a wide range of businesses and found a broad range of royalties for trademark use from a low of 0.7% to a high of 15%.

Advance Against Royalties

In the field of intellectual property licensing, an advance against royalties is a payment made by the licensee to the licensor at the start of the period of licensing (usually immediately upon contract, or on delivery of the property being licensed) which is to be offset against future royalty payments.

For example, a book's author may sell a license to a publisher in return for 5% royalties on sales of the book and a $5,000 advance against those royalties. In this case, the author would immediately receive the $5,000, and royalty payments would be withheld until the publisher's takings from selling copies of the book reached $100,000, after which point the 5% royalty would be paid on any additional sales.

In some business areas (e.g. film production), it is common practice for the licensee to demand repayment of any advance that is not covered by royalties, whereas in others (e.g. book publication) this practice is unusual.