Royalty payment

Not to be confused with Royal family.

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 as a percentage of gross or net sales derived from use of the asset or a fixed price per unit sold and prevail over a defined time-period. . They are usually referred to as 'running royalties'. It is only one of four major methods found in compensation formats. The others involve: (1)allowing the licensor to own a part of the equity of the licensee company (b) making/obtaining staged 'milestone' payments, often encountered in drug development contracts or in commissioned software, and (c) a lumpsum payment made in one or more installments in place of running royalties. They may also be combined in a contract.In all of them the licensor controls the technology.

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.

License agreements

A license agreement defines the terms under which intellectual property such as patents, trademarks, and copyrights is licensed by one company to another, either without restriction or subject to a limitation on term, business or geographic territory, type of product, etc. License agreements are typically private contracts but follow a general structure. However, certain types of franchise agreements and software licenses (for instance, those relating to downloaded music or off-the-shelf 'shrink-wrapped' application software) may have identical provisions.

Patent royalties

A patent gives the owner an exclusive right to prevent others from practicing patented invention 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 to parties by the patent holder in various ways. Some or all the rights to a patent may be licensed 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.

Royalty 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:

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

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.

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%.

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.

Approaches to Royalty Rate Determination and Illustrative Royalties

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There are three general approaches to assess the royalty rate that a licensor can ask for, or for a licensee to be willing to pay, in the licensing of intellectual property. being These are:

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

The 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 and risk undertaken in its development. Costs considered could include R&D expenditures, pilot-plant and test-marketing costs, technology upgrading expenses and the like, together with prospects of its operative life.

It 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, say, 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:

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 the subject of license. The product is accepted under a pre-negotiated royalty schedule depending on the software meeting set stage-wise specifications and acceptable error levels in its performance.

The Comparable Market Approach

Here the cost and the risk of development are disregarded. The royalty rate is determined from a comparison of competing or similar technologies in an industry, the useful 'remaining life' of the technology in that industry and contract elements such as exclusivity provisions, front-end and running royalties, field of use coverage (or restrictions), geographic limitations and the depth of the technology (the mix of patents, know-how, trade-mark strengths, etc. accompanying it).

The prime difficulty with this method is obtaining access to comparable technologies and the terms of the agreements that incorporate them. Fortunately, there are reputable organizations, among them, RoyaltySource, Royalty Stat, 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).

Industry	Licenses (nos.)	Min. Royalty,%	Max. Royalty,%	Average,%	Median,%
Automotive	35	1.0	15.0	4.7	4.0
Computers	68	0.2	15.0	5.2	4.0
Consumer Gds	90	0.0	17.0	5.5	5.0
Electronics	132	0.5	15.0	4.3	4.0
Healthcare	280	0.1	77.0	5.8	4.8
Internet	47	0.3	40.0	11.7	7.5
Mach.Tools.	84	0.5	26	5.2	4.6
Pharma/Bio	328	0.1	40.0	7.0	5.1
Software	119	0.0	70.0	10.5	6.8

Industry	2-2%	2-5%	5-10%	10-15%	15-20%	20-25%
Aerospace	50%	50%
Chemical	16.5%	58.1%	24.3%	0.8%	0.4%
Computer	62.5%	31.3%	6.3%
Electronics		50.0%	25.0%	25.0%
Healthcare	3.3%	51.7%	45.0%
Pharmaceuticals	23.6%	32.1%	29.3%	12.5%	1.1%	0.7%
Telecom	40.0%	37.3%	23.6%

The Income Approach

The Income Approach focuses on what revenues and profits would be generated by the licensee from an optimized employment of the technology.

The approach requires the generation of a cash-flow statement of incomes and expenses over the life-span of the license and evaluating the stream of profits. Profits may arise not only from the value residing within the technology, or its portfolio components (patents, trademarks, etc.), but from thrusts in the general economy in which the technology is exploited. 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).

Since projections can be made under different assumptions of revenue generation, and incomes and costs can be expected to vary from year to year, it is not possible to compare the net income streams through the simple addition of profits. An appropriate method is to calculate the Net Present Value, NPV of future incomes, by the process of discounting future incomes through the use of an appropriate discount factor (for the economy in which the technology will be worked). A higher discount rate is used where there is greater risk of realizing incomes and vice versa. For a licensee, a higher rate of royalty than expected can be compensated by accompanying guaranties (by the licensor or a third party) on the performance of the technology (or demonstration of its effectiveness in different geographies).

It must be noted that in this method, one is not valuing the technology but the income stream from a single licensee. The value of the technology stems from the extent to which it can be licensed to others or the gain from an exclusive license.

The royalty rate is obtained from determining the licensor's share of future profits, or rather, its NPV. Unless there are special situations, the "25%" rule - the licensor obtaining 25% of the operating income - is used as a starting point for negotiations.

See also

• Advance against royalties
• Intellectual property

External links

• " Royalty Rate Websites"
• "CPT page on Royalties on patents for health care inventions"